[Senate Hearing 113-501, Volume 1] [From the U.S. Government Publishing Office] S. Hrg. 113-501 WALL STREET BANK INVOLVEMENT WITH PHYSICAL COMMODITIES ======================================================================= HEARINGS before the PERMANENT SUBCOMMITTEE ON INVESTIGATIONS of the COMMITTEE ON HOMELAND SECURITY AND GOVERNMENTAL AFFAIRS UNITED STATES SENATE ONE HUNDRED THIRTEENTH CONGRESS SECOND SESSION __________ VOLUME 1 OF 2 __________ NOVEMBER 20 and 21, 2014 __________ Available via the World Wide Web: http://www.fdsys.gov Printed for the use of the Committee on Homeland Security and Governmental Affairs S. Hrg. 113-501 WALL STREET BANK INVOLVEMENT WITH PHYSICAL COMMODITIES ======================================================================= HEARINGS before the PERMANENT SUBCOMMITTEE ON INVESTIGATIONS of the COMMITTEE ON HOMELAND SECURITY AND GOVERNMENTAL AFFAIRS UNITED STATES SENATE ONE HUNDRED THIRTEENTH CONGRESS SECOND SESSION ---------- VOLUME 1 OF 2 ---------- NOVEMBER 20 and 21, 2014 ---------- Available via the World Wide Web: http://www.fdsys.gov Printed for the use of the Committee on Homeland Security and Governmental Affairs ______ U.S, GOVERNMENT PRINTING OFFICE 91-653 PDF WASHINGTON : 2014 ----------------------------------------------------------------------- For sale by the Superintendent of Documents, U.S. Government Printing Office Internet: bookstore.gpo.gov Phone: toll free (866) 512-1800; DC area (202) 512-1800 Fax: (202) 512-2104 Mail: Stop IDCC, Washington, DC 20402-0001 COMMITTEE ON HOMELAND SECURITY AND GOVERNMENTAL AFFAIRS THOMAS R. CARPER, Delaware, Chairman CARL LEVIN, Michigan TOM COBURN, Oklahoma MARK L. PRYOR, Arkansas JOHN McCAIN, Arizona MARY L. LANDRIEU, Louisiana RON JOHNSON, Wisconsin CLAIRE McCASKILL, Missouri ROB PORTMAN, Ohio JON TESTER, Montana RAND PAUL, Kentucky MARK BEGICH, Alaska MICHAEL B. ENZI, Wyoming TAMMY BALDWIN, Wisconsin KELLY AYOTTE, New Hampshire HEIDI HEITKAMP, North Dakota Gabrielle A. Batkin, Staff Director Keith B. Ashdown, Minority Staff Director Laura W. Kilbride, Chief Clerk PERMANENT SUBCOMMITTEE ON INVESTIGATIONS CARL LEVIN, Michigan, Chairman MARK L. PRYOR, Arkansas JOHN McCAIN, Arizona MARY L. LANDRIEU, Louisiana RON JOHNSON, Wisconsin CLAIRE McCASKILL, Missouri ROB PORTMAN, Ohio JON TESTER, Montana RAND PAUL, Kentucky TAMMY BALDWIN, Wisconsin KELLY AYOTTE, New Hampshire HEIDI HEITKAMP, North Dakota Elise J. Bean, Staff Director and Chief Counsel Tyler Gellash, Senior Counsel Henry J. Kerner, Minority Staff Director and Chief Counsel Michael Lueptow, Counsel to the Minority Mary D. Robertson, Chief Clerk Patricia R. Hogan, Publications Clerk C O N T E N T S ------ Opening statements: Page Senator Levin................................................ 1, 95 Senator McCain............................................... 7, 98 Senator Portman.............................................. 23 Senator Baldwin.............................................. 33 WITNESSES Thursday, November 20, 2014 Christopher Wibbelman, President and Chief Executive Officer, Metro International Trade Services LLC, Allen Park, Michigan... 10 Jacques Gabillon, Head, Global Commodities Principal Investment Group, Goldman Sachs and Co., London, England.................. 11 Jorge Vazquez, Founder and Managing Director, Harbor Aluminum Intelligence LLC, Austin, Texas................................ 56 Nick Madden, Senior Vice President and Chief Supply Chain Officer, Novelis Inc., Atlanta, Georgia........................ 57 Simon Greenshields, Global Co-Head of Commodities, Morgan Stanley, New York, New York.................................... 68 Gregory A. Agran, Co-Head, Global Commidities Group, Goldman Sachs and Co., New York, New York.............................. 69 John Anderson, Co-Head, Global Commodities Group, JPMorgan Chase and Co., New York, New York.................................... 71 Friday, November 21, 2014 Saule T. Omarova, Professor of Law, Cornell University, Ithaca, New York....................................................... 99 Chiara Trabucchi, Principal, Industrial Economics, Incorporated, Cambridge, Massachusetts....................................... 101 Hon. Daniel K. Tarullo, Member, Board of Governors of the Federal Reserve System, Washington, DC................................. 119 Larry D. Gasteiger, Acting Director, Office of Enforcement, Federal Energy Regulatory Commission, Washington, DC........... 120 Alphabetical List of Witnesses Agran, Gregory A.: Testimony.................................................... 69 Prepared statement........................................... 274 Anderson, John: Testimony.................................................... 71 Prepared statement........................................... 277 Gabillon, Jacques: Testimony.................................................... 11 Prepared statement with an attached chart.................... 142 Gasteiger, Larry D.: Testimony.................................................... 120 Prepared statement........................................... 325 Greenshields, Simon: Testimony.................................................... 68 Prepared statement........................................... 268 Madden, Nick: Testimony.................................................... 57 Prepared statement........................................... 164 Omarova, Saule T.: Testimony.................................................... 99 Prepared statement........................................... 282 Tarullo, Hon. Daniel K.: Testimony.................................................... 119 Prepared statement........................................... 313 Trabucchi, Chiara: Testimony.................................................... 101 Prepared statement........................................... 302 Vazquez, Jorge: Testimony.................................................... 56 Prepared statement........................................... 148 Wibbelman, Christopher: Testimony.................................................... 10 Prepared statement........................................... 139 APPENDIX Report by the Permanent Subcommittee on Investigations Majority and Minority Staff entitled ``Wall Street Bank Involvement With Physical Commodities,'' November 20 and 21, 2014............... 341 EXHIBIT LIST VOLUME 1 1. a. GGlobal LME Aluminum Stocks, chart prepared by the Permanent Subcommittee on Investigations....................... 816 b. GMetro Freight Incentives, chart prepared by Goldman Sachs. [Source: Goldman Sachs Counsel letter to the Permanent Subcommittee on Investigations, GSPSICOMMODS00046232, included in Exhibit 39]................................................. 817 c. GAluminum Tonnage Shipped (Metro Warehouse (Detroit) to Metro Warehouse (Detroit)), chart prepared by Goldman Sachs. [Source: Goldman Sachs Counsel letter to the Permanent Subcommittee on Investigations, PSI-GoldmanSachs-20-000002].... 818 d. GGoldman Employees Who Served As Metro Board Members, 2009 to 2014, chart prepared by the Permanent Subcommittee on Investigations................................................. 819 e. GAluminum Merry Go Round Transactions, chart prepared by the Permanent Subcommittee on Investigations................... 820 f. GDetroit Queue and Platts MW Aluminum Premium, chart prepared by the Permanent Subcommittee on Investigations....... 821 g. GWentworth Ownership Structure, chart prepared by the Permanent Subcommittee on Investigations....................... 822 h. GOverview of North America Gas, Power and PI Assets, as of 03/31/2011, chart prepared by JPMorgan. [FRB-PSI-623097, included in Exhibit 58]........................................ 823 i. GJPMorgan internal email, dated October 2010, re: Please sir! mor BCR!!!!............................................... 824 j. GExcerpts from 2013 CNR Financial Statement, prepared by CNR. [GSPSICOMMODS00046374, included in Exhibit 17]............ 825 k. GQueue Length, chart prepared by the Permanent Subcommittee on Investigations................................. 826 Documents Related to Goldman Sachs/General: 2. GExcerpts of Goldman Sachs responses to questions from the Federal Reserve on 4(o) Commodities Activities, dated May 26, 2011, re: 1997 v. 2010 physical commodity activities. [FRB-PSI- 200600-602, 608-610]........................................... 827 3. GExcerpts from Goldman Sachs Presentation, Federal Reserve Bank of New York Discovery Review: Global Commodities - US Natural Gas & Power, dated March 2010, (Financial vs. Physical Trades FY 2009). [FRB-PSI-400006, 008]......................... 833 4. GGoldman Sachs Presentation, Global Commodities, Presentation to the Board of Directors of The Goldman Sachs Group, Inc., dated October 2011, including Metro, CNR and Cogentrix highlights. [FRB-PSI-700011-030]............................... 835 5. GExcerpts from Goldman Sachs Memorandum, dated July 2012, re: Firmwide Client and Business Standards Committee Meeting, (... Merchant Banking include CNR, Metro and Vale. ... *** ... Nufcor - treated as part of firm's own activities). [FRB-PSI- 200984, 994-996, 998-1001, 1004, 1006-007]..................... 855 6. GGoldman Sachs Memorandum to the Federal Reserve, dated July 2013, re: commodity-related activities, including environmental/catastrophic risk. [FRB-PSI-201245-268].......... 866 7. GGoldman Sachs Presentation, Global Commodities & Global Special Situations Group, Presentation to the Board of Directors of The Goldman Sachs Group, Inc., dated September 2013, including Metro and CNR (short coal hedge) highlights. [FRB-PSI-400077-098]........................................... 889 8. GConsolidated Holding Company Report of Equity Investments in Nonfinancial Companies - FR Y-12, dated June 30, 2014, prepared by The Goldman Sachs Group, regarding its merchant banking investments. [FRB-PSI-800013-016].............................. 910 Documents Related to Goldman Sachs Involvement with Uranium: 9. GGoldman Sachs New Product Memorandum, dated December 2008, re: Uranium Trading. [FRB-PSI-400039-052]...................... 914 10. GGoldman Sachs Physical Commodity Review Committee: Meeting Minutes, dated May 2013, re: enriched uranium (UF6). [FRB-PSI- 400053-055].................................................... 928 11. GNufcor - Structure Chart, prepared by Goldman Sachs. [GSPSICOM-MODS00046240]........................................ 931 12. GExcerpts from Goldman Sachs counsel letter to the Subcommittee, dated October 2014, re: Nufcor, attached chart, Nufcor Uranium Utility Supply Contracts at the time of the Nufcor Acquisition (June 30, 2009)). [PSI-GoldmanSachs-21- 000001-010 and GSPSICOMMODS00046532-533]....................... 932 Documents Related to Goldman Sachs Involvement with Coal: 13. GCNR Structure Chart, prepared by Goldman Sachs. [GSPSICOMMODS-00046318]........................................ 944 14. GExcerpt from Coalcorp Mining Inc., Notice of Special Meeting of Shareholders to be Held on February 11, 2010 and Management Information Circular. [PSI-CI-01-000001-003, 019-020, 025-028]. 945 15. GGoldman Sachs submission to the Federal Reserve, Report of Changes in Organizational Structure - FR Y-10, dated April 2010, re: CNR. [GSPSICOMMODS00046301-303]...................... 954 16. GExcerpt from C.I. Colombian Natural Resources I SAS and J. Aron & Company Marketing Agreement, dated September 2011. [GSPSI-COMMODS00046496-501, 509]............................... 957 17. GExcerpt from C.I. Colombian Natural Resources I S.A.S, Financial Statements for the years ended on the 31st of December of 2013 and 2012 and Statutory Auditor's Report, dated March 2014. [GSPSICOM-MODS00046366-367, 369, 373-376, 382-383, 391-395]....................................................... 964 18. GGoldman Sachs counsel letter to the Subcommittee, dated October 2014, re: CNR and Nufcor. [PSI-GoldmanSachs-19-000001- 009]........................................................... 978 19. GGoldman Sachs counsel letter to the Subcommittee, dated November 2014 (... J. Aron acted as the exclusive marketing and sales agent for CNR.). [PSI-GoldmanSachs-25-000001-003]........ 987 20. GGoldman Sachs Metals & Mining, Background to Environmental and Social Due Diligence, last updated 2012. [FRB-PSI-300221- 230]........................................................... 990 Documents Related to Goldman Sachs Involvement with Aluminum: 21. GExcerpt from Goldman Sachs counsel letter to the Subcommittee, dated October 2014, including chart, Aluminum Tonnage Shipped (Metro Warehouse (Detroit) to Metro Warehouse (Detroit)). [PSI-GoldmanSachs-20-000001-002]................... 1000 22. a. GInvoice List of Glencore Ltd. and Red Kite Master Fund Limited. [GSPSICOMMODS00046871-872]............................ 1002 b. GGlencore Ltd. invoice to Metro International Trade, dated June 21, 2013, in the amount of $9,909,280.66. [GSPSICOMMODS00046873]......................................... 1004 c. GGlencore Ltd. invoice to Metro International Trade, dated June 21, 2013, in the amount of $402,190.77. [GSPSICOMMODS00046874]......................................... 1005 d. GGlencore Ltd. invoice to Metro International Trade, dated September 24, 2013, in the amount of $321,105.33. [GSPSICOMMODS00046875]......................................... 1006 e. GRed Kite Master Fund Limited invoice to Metro International Trade, dated November 13, 2012, in the amount of $5,735,700. [GSPSICOMMODS00046876]............................. 1007 f. GRed Kite Master Fund Limited invoice to Metro International Trade, dated December 20, 2012, in the amount of $632,720. [GSPSI-COMMODS00046877].............................. 1008 g. GRed Kite Master Fund Limited invoice to Metro International Trade, dated January 28, 2014, in the amount of $2,932,731.43. [GSPSI-COMMODS00046878]......................... 1009 h. GRed Kite Master Fund Limited invoice to Metro International Trade, dated January 28, 2014, in the amount of $14,084,464.63. [GSPSICOMMODS00046879]......................... 1010 23. GWarrant Finance Agreement, DB Energy Trading LLC and Metro International Trade Services LLC, dated September 2010. [GSPSICOMMODS-0047434-447]..................................... 1011 24. GExcerpt from Goldman Sachs Presentation, MITSI Holdings LLC, Board of Directors Meeting, dated December 2012, slide entitled Overview Off-warrant Deals, re: Red Kite deals. [GSPSICOMMODS00009348]......................................... 1025 25. GMetro internal email, dated November 2012, re: Detroit Ali - off warrant storage deal. [GSPSICOMMODS00046684-686]........... 1026 26. GGlencore/Metro email exchange, dated April 2013, re: New Deal 09 Glencore Detroit (... all 91,000 mt for Glencore scheduled to ship outbound in May/June will do so as scheduled but will go to other Metro locations in Detroit (we of course decide) and remain off warrant until June/July 2013 at which point the material will be rewarranted.). [PSICOMMODS00046687- 691]........................................................... 1029 27. GCharts related to last Red Kite deal and Glencore deal, prepared by Metro for LME in 2014. [GSPSICOMMODS00046666-683].. 1034 28. GMetro internal email, dated December 2010, re: Montreal (... blocking others. *** ... Q management.). [GSPSICOMMODS00047422] 1052 29. GMetro internal email, dated February 2012, re: Stemcor 12 kt to Detroit (... queue management.). [GSPSICOMMODS00047423-429]. 1053 30. GMetro internal email of Michael Whelan, dated June 2013, re: Resignation (I have some questions and concerns regarding the Chinese Wall Policy that is in place which regulates the interaction between Metro International, its customers, and J Aron. This morning's confrontation was extremely questionable.) [GSPSICOMMODS00047430]......................................... 1060 31. GMetro International Trade Services (2011-2013) and (2014), charts regarding agreements of sharing physical premiums. [GSPSICOMMODS-00046531, 46630]................................. 1061 32. GGoldman Sachs chart, Metro International Trade Services, Management Brief, June 2011 (Extraordinary income from counterparties sharing physical premium with Metro ...). [GSPSICOMMODS00009668]......................................... 1063 33. GLME counsel letter to the Subcommittee, dated November 2014 (... while the LME would view such behavior as a contravention of the ``spirit'' of the relevant requirements, it may be difficult to argue that it constituted a contravention of the ``letter'' of those requirements.). [LME_PSI0002459-462]....... 1064 34. GAluminum Users Group Memorandum, dated October 2012 (The LME's terminal market model ... is broken.). [PSI- AlumUsersGroup-01-000010-012].................................. 1068 35. GGoldman Sachs Presentation to Firmwide Client and Business Standards Committee, Metro International Trade Services, dated August 2011, including slide entitled, Metro Financial Summary. [FRB-PSI-707486-500]........................................... 1071 36. a. GGoldman Sachs Presentation, MITSI Holdings LLC, Board of Directors Meeting, dated December 2011, including slide entitled Current Deal Pipeline. [GSPSICOMMODS00009287-309]..... 1086 b. GGoldman Sachs Presentation, MITSI Holdings LLC, Board of Directors Meeting, dated March 2012, including slides entitled Current Deal Pipeline and Overview Off-warrant Deals. [GSPSICOMMODS-00009423-449].................................... 1109 c. GGoldman Sachs Presentation, MITSI Holdings LLC, Board of Directors Meeting, dated December 2012, including slides entitled Current Deal Pipeline and Overview Off-warrant Deals. [GSPSICOMMODS-00009332-353].................................... 1136 d. GGoldman Sachs Presentation, MITSI Holdings LLC, Board of Directors Meeting, dated March 2013, including slides entitled Current Deal Pipeline and Metro's Annual Financial Performance. [GSPSICOMMODS-00009355-377].................................... 1157 37. GLondon Metal Exchange (LME) document listing Terms and conditions applicable to all LME listed warehouse companies, dated April 2014. [LME_PSI0001406-427]......................... 1178 38. a. GConflict Management Procedures Between Metro and Other GS Businesses and Personnel, Policy Issued To: Global Commodities Sales and Trading, Global Commodities Principal Investment, Metro Board Members, Metro Management and Staff, dated February 2010. [FRB-PSI-602457-471]..................................... 1200 b. GInformation Barrier Policy: Metro and Other GS Businesses and Personnel, For: Global Commodities Sales and Trading, Global Commodities Principal Investments, Metro Board Members, Metro Management and Staff, dated March 2014. [GSPSICOMMODS00004059-076]..................................... 1215 39. GExcerpt from Goldman Sachs counsel letter to the Subcommittee, dated September 2014, including table listing Total Annual Freight Allowance Paid by Metro and Annual Freight Allowance Paid by Metro to J. Aron. [PSI-GoldmanSachs-15-000001 and GSPSICOMMODS00046232-233].................................. 1233 40. GExcerpts from Goldman Sachs counsel letter to the Subcommittee, dated August 2014, including list of authorized Goldman Sachs employees given access to confidential information. [PSI-GoldmanSachs-17-000001 and GSPSICOMMODS00046225-226]...................................... 1236 Documents Related to Morgan Stanley/General: 41. GMorgan Stanley Presentation, Global Commodities Overview, dated May 2009. [FRB-PSI-618889-908]........................... 1239 42. GMorgan Stanley Presentation, Morgan Stanley Commodities, Business Overview, dated February 2013, prepared for the Permanent Subcommittee on Investigations. [PSI-MorganStanley- 01-000001-027]................................................. 1259 43. GConsolidated Holding Company Report of Equity Investments in Nonfinancial Companies - FR Y-12, dated June 30, 2014, prepared by Morgan Stanley, regarding its merchant banking investments. [FRB-PSI-800009-012]........................................... 1286 Documents Related to Morgan Stanley Involvement with Natural Gas: 44. GExcerpt from Morgan Stanley Presentation, Federal Reserve Bank of New York, Morgan Stanley Infrastructure Platform Review, prepared by Morgan Stanley, dated September 2013. [FRB- PSI-400321-329, 331 333, 341, 351-352, 365-366]................ 1290 45. a. GApplication of Wentworth Gas Marketing LLC for Long-Term Authorization to Export Compressed Natural Gas, submitted to the Department of Energy, Office of Fossil Energy, dated May 2014........................................................... 1307 b. GDepartment of Energy, Office of Fossil Energy, In re Wentworth Gas Marketing LLC, Order Granting Long-Term Authorization To Export Compressed Natural Gas, dated October 2014. [PSI-DOE-01-000004-016].................................. 1326 46. GExcerpt from Morgan Stanley Presentation, Morgan Stanley Infrastructure Partners, Overview of Southern Star, dated August 2014. [MS-PSI-00000001-016, 019-020, 023-027, 035, 037]. 1339 47. GMorgan Stanley counsel letter to the Subcommittee, dated September 2014, re: ... Morgan Stanley's purchase of the Deutsche Bank natural portfolio and involvement with Wentworth Holdings, LLC. [PSI-MorganStanley-13-000001-009]............... 1364 48. GExcerpt from Morgan Stanley Presentation, Morgan Stanley Infrastructure Partners, Southern Star Follow Up Questions, dated October 2014. [MS-PSI-00000455-460, 465-469, 472-475].... 1373 Documents Related to Morgan Stanley Involvement with Crude Oil: 49. GExcerpts from Morgan Stanley counsel letter to the Subcommittee, dated October 2014, re: early New York oil storage. [PSI-MorganStanley-17-000001-002]..................... 1387 50. GExcerpts from Morgan Stanley counsel letter to the Subcommittee, dated June 2013, re: TransMontaigne. [PSI- MorganStanley-06-000001-004]................................... 1389 51. GExcerpts from Morgan Stanley counsel letter to the Subcommittee, dated October 2014, re: oil storage data, revenue, and Olco Petroleum Group. [PSI-MorganStanley-19- 000001-003].................................................... 1393 Documents Related to Morgan Stanley Involvement with Jet Fuel: 52. GExcerpts from Jet Fuel Supply Agreement between Morgan Stanley Capital Group Inc. and United Airlines, Inc. and United Aviation Fuels Corporation, dated September 2003. [PSI- UnitedAirlines-01-000003, 013, 016, 020-022]................... 1396 53. GMorgan Stanley counsel letter to the Subcommittee, dated September 2014, re: Emirates. [PSI-MorganStanley-15-000001-004] 1402 54. GEmirates counsel letter to the Subcommittee, dated October 2014, re: jet fuel purchases and hedges. [PSI-Emirates-01- 000001-004].................................................... 1406 55. GEmirates counsel letter to the Subcommittee, dated October 2014, re: jet fuel purchases and hedges. [PSI-Emirates-02- 000001-007].................................................... 1410 Documents Related to JPMorgan Chase/General: 56. a. GNotice to the Board of Governors of the Federal Reserve System by JPMorgan Chase & Co., submitted July 21, 2005, requesting complementary authority for physical commodity activities. [PSI-FederalReserve-01-000004-028]................. 1417 b. GNotice to the Board of Governors of the Federal Reserve System by JPMorgan Chase & Co., submitted November 25, 2008, requesting complementary authority for refining activities. [PSI-Federal Reserve-01-000553-558]............................ 1442 57. GFederal Reserve letter to JPMorgan Chase, dated April 20, 2009, granting complementary authority, re: refining activities. [PSI-FRB-11-000001-002]............................ 1448 58. GJPMorgan Presentation, Global Commodities - Operating Risk, dated April 2011. [FRB-PSI-623086-127]......................... 1450 59. GJPMorgan Chase physical inventory positions, 2008-2012. [JPM-COMM-PSI-000015-016]...................................... 1491 60. GMerchant Banking Investment in Henry Bath, undated, prepared by JPMorgan. [FRB-PSI-000580-582].............................. 1493 61. GExcerpt from JPMorgan Presentation, Commodities Physical Operating Risk, Update to CIBRC, dated January 2013, with slide entitled Physical Operating Risk Review of Project Liberty. [FRB-PSI-301379, 381].......................................... 1496 62. GConsolidated Holding Company Report of Equity Investments in Nonfinancial Companies - FR Y-12, dated June 30, 2014, prepared by JPMorgan, regarding its merchant banking investments. [FRB- PSI-800005-008]................................................ 1498 63. GExcerpts from Global & Regional Investment Bank League Tables - 1H2014, dated September 2014, prepared by Coalition Analytics Intelligence. [PSI-Coalition-01-000019-021].......... 1502 64. GJPMorgan Chase counsel letter to the Subcommittee, dated June 2014, re: J.P.Morgan Ventures Energy Corporation (JPMVEC). [PSI-JPMC-11-000001-002]....................................... 1505 65. GJPMorgan Chase counsel letter to the Subcommittee, dated October 2014, re: JPMVEC and Project Liberty. [PSI- JPMorganChase-14-000001-009]................................... 1507 66. GJPMorgan Chase counsel letter to the Subcommittee, dated October 2014, re: various commodity issues. [PSI-JPMorgan-15- 000001-008].................................................... 1516 Documents Related to JPMorgan Chase Involvement with Electricity: 67. GPower Plants Owned or Controlled via Tolling Agreements, 2008 to present, chart prepared by JPMorgan. [JPM-COMM-PSI- 000022-025].................................................... 1524 68. GFederal Reserve Bank of New York letter to JPMorgan Chase, dated March 2008, granting 2-year grace period for power plants and other assets acquired from The Bear Stearns Companies Inc. [FRB-PSI-900001-003]........................................... 1528 69. GExcerpts from JPMorgan Presentation, Global Commodities Deep Dive Risk Review, dated October 2009. [FRB-PSI-200634-638, 640- 642, 644-645, 649-655]......................................... 1531 70. a. GNotice to the Board of Governors of the Federal Reserve System by JPMorgan Chase & Co., submitted December 30, 2009, requesting complementary authority for energy management activities. [PSI-FederalReserve-01-000561-567]................. 1548 b. GNotice to the Board of Governors of the Federal Reserve System by JPMorgan Chase & Co., submitted December 30, 2009, requesting complementary authority for tolling activities. [PSI-FederalReserve-02-000012-033]............................. 1555 71. GJPMorgan letter to the Federal Reserve, dated February 2010, requesting extension and additional complementary authority. [FRB-PSI-300286-290]........................................... 1577 72. GFederal Reserve letter to JPMorgan Chase, dated June 2010, granting complementary authority regarding power plants. [FRB- PSI-302571-580]................................................ 1582 73. GJPMorgan Transaction Overview, dated August 2010, regarding purchase of Kinder Morgan Power Plant. [FRB-PSI-300066]........ 1592 74. GUndated document prepared by JPMorgan regarding power plant restructuring. [FRB-PSI-300352-353]............................ 1593 75. GJPMorgan Presentation, Commodities Operational Risk Capital, dated May 2011. [FRB-PSI-300727-736]........................... 1595 76. GJPMorgan internal email, dated April 2010, re: Resume for Power, attaching resume of John Howard Bartholomew (Identified a flaw in the market mechanism Bid Cost Recovery that is causing the CAISO to misallocate millions of dollars.). [PSI- FERC-02-000009-010]............................................ 1605 77. GJPMorgan internal email, dated October 2010, re: Please sir! mor BCR!!!! [PSI-FERC-02-000042]............................... 1607 78. GJPMorgan internal email from Francis Dunleavy to Blythe Masters, dated March 2011, re: CAISO update (I will handle it but it may not be pretty.). [PSI-FERC-02-000067]............... 1608 Documents Related to JPMorgan Chase Involvement with Copper: 79. GJPMorgan Presentation, JPM Commodity Capabilities, dated January 2012. [FRB-PSI-200832-865]............................. 1609 80. GExcerpt from JPMorgan Presentation, FED/OCC Quarterly Meeting, dated February 2013, including slide entitled, Physical Inventory Limits from FED & OCC. [FRB-PSI-301443, 447] 1639 81. GFederal Reserve email to the Subcommittee, dated October 2014, re: treating copper as ``bullion.'' [PSI-FRB-16-000001].. 1641 82. GJPMorgan counsel email to the Subcommittee, dated October 2014, re: metals trading desk. [PSI-JPMorgan-16-000001]........ 1642 83. GJPMorgan counsel letter to the Subcommittee, dated October 2014, re: JPMorgan copper activities. [PSI-JPMorgan-18-000001- 008 and JPM-COMM-PSI-000064-066]............................... 1643 84. GOCC Interpretive Letter No. 553, dated May 1991, re: treating platinum as bullion. [PSI-OCC-01-000112-113].......... 1651 85. GOCC Interpretive Letter No. 693, dated December 1995, re: treating copper as bullion. [PSI-OCC-01-000135-141]............ 1653 86. a. GComment Letter from Senator Carl Levin to the Securities and Exchange Commission, dated, July 2012, re: JPM XF Physical Copper Trust Pursuant to NYSE Area Equities Rule 8.201......... 1660 b. GComment Letter from Senator Carl Levin to the Securities and Exchange Commission, dated, March 2013, re: JPM XF Physical Copper Trust, Form S-1 Registration Statement.................. 1667 87. GComment Letter from law firm representing copper fabricating companies to the Securities and Exchange Commission, dated July 2012, re: rule change allowing copper ETF. [PSI- VandenbergFeliu_to_SEC(July2012)-000001-005]................... 1682 88. GLME email to the Subcommittee, dated November 2014: re: LME's Public Warrant Banding Report, dated December 15, 2010. [PSI-LME-06-000001]............................................ 1687 Documents Related to JPMorgan Chase Involvement with Size Limits: 89. GMethodology for Calculating Capacity Payments for Purposes of 5% Limit, undated, prepared by JPMorgan. [FRB-PSI-300345- 347]........................................................... 1688 90. GExcerpt from JPMorgan Presentation, FED/OCC/FDIC Quarterly Meeting, dated September 2013, Physical Inventory Limits from FED & OCC. [FRB-PSI-301383, 387]............................... 1691 91. GExcerpt from JPMorgan Chase counsel letter to the Subcommittee, dated October 2014, including chart with inventory levels for copper, platinum, and palladium as of September 28, 2012 held by JPMorgan Chase Bank. [PSI-JPMorgan- 15-000001 and JPM-COMM-PSI-000048-049]......................... 1693 92. GJPMorgan internal email, dated January 2012, re: Consolidated OCC Summary 10 Jan 2012, providing inventory levels for metals held by JPMorgan Chase Bank. [OCC-PSI- 00000336]...................................................... 1696 93. GJPMorgan internal email, dated January 2012, re: Consolidated OCC Summary 19 Jan 2012 (... took further action yesterday to lend 100k tonnes of materials to the market as well as sell 400k tonnes of material to JPMVEC.). [OCC-PSI- 00000344]...................................................... 1697 94. GJPMorgan internal email, dated January 2012, re: Consolidated OCC Summary 19 Jan 2012 (It will not happen again that you learn about it after the fact when it is an issue within our control.). [OCC-PSI-00000340]....................... 1698 95. GJPMorgan internal email, dated February 2012, re: 5% Limit Calculation (Following are our current and proposed methodologies for calculating the [OCC] 5% limit.). [OCC-PSI- 00000324]...................................................... 1699 96. GJPMorgan Chase counsel email to the Subcommittee, dated November 2014, (JPMCB's daily aluminum inventory values and the corresponding LME cash price for aluminum.). [PSI-JPMorgan-23- 000001]........................................................ 1700 97. GExcerpt from JPMorgan Chase counsel letter to the Subcommittee, dated October 2014, re: aluminum trades and 5% limit. [PSI-JPMorgan-17-000001-002]............................ 1701 98. GExcerpt from JPMorgan Chase counsel letter to the Subcommittee, dated November 2014, re: JPMCB aluminum holdings. [PSI-JPMorgan-19-000001-003]................................... 1703 99. a. GMetro legal counsel letter to LME, dated January 27, 2014. [GSPSICOMMODS00046661-665]............................... 1706 b. GMetro legal counsel letter to LME, dated April 15, 2014. [GSPSICOMMODS00046834-848]..................................... 1711 100.a. GResponses of Hon. Daniel K. Tarullo, Federal Reserve System, to supplemental questions for the record from Senator Carl Levin..................................................... 1726 b. GResponses of Chiara Trabucchi, Industrial Economics, Incorporated, to supplemental questions for the record from Senator Carl Levin............................................. 1735 101.a. GResponses of Gregory A. Agran, Goldman Sachs & Co., to supplemental questions for the record from Senator Kelly Ayotte......................................................... 1739 b. GResponses of John Anderson, JPMorgan Chase & Co., to supplemental questions for the record from Senator Kelly Ayotte......................................................... 1745 c. GResponses of Simon Greenshields, Morgan Stanley, to supplemental questions for the record from Senator Kelly Ayotte......................................................... 1751 102.a. GResponses of Jorge Vazquez, Harbor Aluminum Intelligence Unit, LLC, to supplemental questions for the record from Senator Tammy Baldwin.......................................... 1754 b. GResponses of Nick Madden, Novelis, Inc., to supplemental questions for the record from Senator Tammy Baldwin............ 1759 VOLUME 2 103. GDocument Locator List and documents cited in footnotes to ``Wall Street Bank Involvement With Physical Commodities,'' the Report released in conjunction with the Subcommittee hearing on November 20 and 21, 2014. The Document Locator List provides the Bates numbers or a description of the documents cited in the Report and the hearing record page number where the document can be located. Not included are documents related to Subcommittee interviews, which are not available to the public, and widely available public documents.......................... 1763 WALL STREET BANK INVOLVEMENT WITH PHYSICAL COMMODITIES ---------- THURSDAY, NOVEMBER 20, 2014 U.S. Senate, Permanent Subcommittee on Investigations, of the Committee on Homeland Security and Governmental Affairs, Washington, DC. The Subcommittee met, pursuant to notice, at 9:34 a.m., in room SD-106, Dirksen Senate Office Building, Hon. Carl Levin, Chairman of the Subcommittee, presiding. Present: Senators Levin, Pryor, Baldwin, McCain, and Portman. Staff present: Elise J. Bean, Staff Director and Chief Counsel; Mary D. Robertson, Chief Clerk; Tyler Gellasch, Senior Counsel; Adam Henderson, Professional Staff Member; Angela Messenger, Detailee (GAO); Joel Churches, Detailee (IRS); Ahmad Sarsour, Detailee (FDIC); Tom McDonald, Law Clerk; Tiffany Eisenbise, Law Clerk; Tiffany Greaves, Law Clerk; Ken Reidy (Sen. Baldwin); Henry J. Kerner, Staff Director and Chief Counsel to the Minority; Michael Lueptow, Counsel to the Minority; Scott Wittmann, Research Assistant to the Minority; Elise Mullen, Research Assistant to the Minority; Kyle Brosnan, Law Clerk to the Minority; Christina Bortz, Law Clerk to the Minority; Jennifer Junger, Law Clerk to the Minority; Ferdinand Kramer, Law Clerk to the Minority; Chapin Gregor, Law Clerk to the Minority; and Derek Lyons (Sen. Portman). OPENING STATEMENT OF SENATOR LEVIN Senator Levin. Good morning, everybody. Today, the Subcommittee meets to discuss the product of a 2-year investigation into Wall Street bank involvement with physical commodities. Our 396-page bipartisan Report with nearly 800 pages of exhibits provides facts and details that, for too long, have been missing from the public debate about the growing role of large Wall Street banks in sectors of the economy outside of banking--in this case, activities involving physical commodities such as oil, metal, coal, and electricity--while at the same time trading in financial instruments whose value could be affected by a bank's involvement with those physical commodities. For more than a century, the United States, by law and practice, has worked to maintain the separation of banking from commerce, directing banks to concentrate on taking deposits, transferring funds, and providing credit, and to avoid commercial activities like supplying oil, producing electricity, or storing aluminum. The principle of separating banking from commerce wisely seeks to reduce risk to the economy and risk to the integrity of commodity markets. Our investigation found that this principle has eroded and, predictably, that erosion has increased risk for the economy, markets, industry, and consumers. We found that banks--and for clarity's sake, I will use that term generically to refer to federally insured banks and their holding companies registered with the Federal Reserve--we found that banks have vastly accelerated their physical commodity activities, and are competing directly with commercial businesses that lack the big banks' easy access to government-subsidized capital. At the same time, these banks have taken on dramatic new risks--risks that, because of the size of these banks, fall not just on them, but on the larger financial system and, therefore, our entire economy. In addition, their activities raise significant questions about whether banks are profiting at the expense of end-users who must wait longer and pay more for critical raw materials. And they give Wall Street the opportunity to use valuable non-public information to gain unfair trading advantages or to profit from the manipulation of prices. Today's hearing will focus on the activities of three major banks--Goldman Sachs, JPMorgan Chase, and Morgan Stanley--that over the last 10 years have become very active in physical commodity markets. If you like what Wall Street did for the housing market, you will love what Wall Street is doing for commodities. Some of the same people who brought us the synthetic mortgage-backed security--and with it, the term ``toxic asset'' and the recent financial crisis--now dominate the commodities futures markets. Producers and end users once held 70 percent of commodities futures; by 2011, that had fallen to about 30 percent, with the majority of futures held by speculators looking to profit from price volatility. This means commodities markets are increasingly unable to fulfill their purpose--which is to allow end-users, from shipbuilders to beverage companies, and from automakers to airlines, to manage their risks. These Wall Street banks have stored and sold aluminum, operated coal mines and metal warehouses, stockpiled aluminum and copper, operated oil and gas storage facilities and pipelines, planned a compressed natural gas facility, supplied oil refineries, sold jet fuel to airlines, and operated power plants. They have acquired staggeringly large positions and executed massive trades in oil, metal, and other physical commodities. While Wall Street's growing role in physical commodities has been discussed and debated, the scope of this involvement, and the potential for abuse, have not been widely known. Those physical commodity activities bring with them many risks. Goldman Sachs' involvement with uranium and coal mines exposed it to the kinds of environmental and catastrophic-event risks that traditional banks do not usually face. Morgan Stanley used shell companies in its plans to build a compressed natural gas plant, exposing itself then to direct liability should disaster strike. The Federal Reserve recently reported: ``[C]atastrophes involving environmentally sensitive commodities may cause fatalities and economic damages well in excess of the market value of the commodities involved or the committed capital and insurance policies of market participants.'' Should a catastrophe occur, it could undermine a bank or spur fears that it might fail, sparking a bank run, a shut-down of lending, and turmoil in the U.S. economy. Wall Street has made legal arguments contending that its liability risk is limited and manageable. But at times even the banks acknowledge that they could be held liable if they, for example, are negligent in managing these activities. And even if courts eventually upheld a bank's legal defense, even the possibility of liability judgments on the scale of a Deepwater Horizon or Exxon Valdez could freeze a bank's access to capital and risk a Lehman Brothers-style crisis. And there is much more. Bank involvement with physical commodities also raises concerns about unfair trading. In some cases, banks have been implicated in outright market manipulation. JPMorgan recently paid $410 million to settle charges by the Federal Energy Regulatory Commission that it used manipulative bidding schemes at its power plants to elicit $124 million in excessive electricity payments in California and Michigan. Activities involving physical commodities also give Wall Street banks access to valuable non-public information with which they can profit in physical and financial commodity markets at the expense of other market participants. The banks and their regulator, the Federal Reserve, acknowledge as much. JPMorgan, in a 2005 application for authority to make physical commodities investments, said that its plan would ``provide access to information regarding the full array of actual [production] and end-user activity in those markets.'' And it went on: ``The information gathered through this increased market participation will help improve projections of forward and financial activity and supply vital price and risk management information that JPM Chase can use to improve its financial commodities derivative offerings.'' Similarly, a Morgan Stanley executive publicly spoke of the advantage of its involvement in oil storage and pipelines: ``We're right there seeing terminals filling up and emptying.'' And a Fed analysis of Morgan Stanley and Goldman Sachs said the banks' physical commodities activities provided ``important asymmetrical information--which a market participant without physical infrastructure would not necessarily be privy to.'' Our bipartisan Report contains nine case studies illustrating the risks and unfair trading concerns raised by bank involvement with physical commodities. Each is worthy of its own hearing. Today we will examine activities at three banks, and we will highlight one case study in particular, to demonstrate how actions taken by a single financial institution--in this case Goldman Sachs--in a single commodity--aluminum--has given that Wall Street giant the ability to affect prices and supplies of that commodity while trading in financial instruments related to that commodity. In 2010, Goldman Sachs bought a company called Metro International Trade Services, which owns a global network of warehouses certified by the London Metal Exchange, or LME, the world's largest market for trading metals. LME certification means that Metro can store metal that has been warranted as meeting LME standards for quality and quantity and is approved for use in settling LME aluminum trades. Under Goldman's ownership, Metro mounted an unprecedented effort to dominate the North American market for storing aluminum. By early this year, Goldman's warehouses in the Detroit area held nearly 1.6 million metric tons of aluminum--roughly 25 percent of the annual aluminum consumption in North America--and 85 percent of the LME-warranted aluminum in the United States. Now, why is this important? Because aluminum warehouses owned by Goldman, and overseen by a board consisting entirely of Goldman employees, manipulated their operations in a way that impacted the price of aluminum for consumers, while at the same time Goldman was trading in aluminum-related financial products. Goldman's subsidiary achieved this dominant position through aggressive incentives for metal owners to store aluminum in its warehouses--incentives that appear to be inconsistent with the LME's prohibition on ``exceptional inducements.'' One set of incentives involved a series of ``merry-go-round'' transactions that bottled up millions of tons of aluminum and appears to have affected prices for businesses and consumers. Those merry-go-round transactions first came to the public's attention through a 2013 New York Times article. We dug into the facts behind the story and uncovered a troubling set of practices that included six merry-go-round trades involving more than 600,000 metric tons of aluminum. To remove LME-warranted metal from an LME warehouse, the metal's owner must cancel its warrants and pay any rent or storage bills. Then the metal is placed in line for load-out. That line is the ``queue'' which you will hear a lot about today. Until Goldman bought Metro, aluminum in the load-out line was shipped from a warehouse in a matter of days or weeks. But as you can see from that chart we have up there, Exhibit 1f,\1\ since Goldman's acquisition of Metro, the queue to exit the Detroit warehouses has gotten longer and longer. In January 2010, it was about 40 days; by September of this year, it had grown to an unprecedented 600 days. Why? Because of actions taken by Metro, the Goldman-owned warehouse operator. And what difference does it make? A big difference. The price consumers must pay for aluminum is made up of the benchmark price set on the LME's exchange, plus a regional premium based on regional storage and logistics costs. The longer the queue, the higher the storage costs, and the higher the storage costs, the higher the premium consumers must pay. Statistical analysis shows an extremely high correlation between the length of the queue and the U.S. premium level. --------------------------------------------------------------------------- \1\ See Exhibit No. 1f, which appears in the Appendix on page 821. --------------------------------------------------------------------------- LME rules require that warehouses each day load out a minimum quantity of metal. That minimum was 1,500 metric tons a day for large warehouses such as Metro's, until April 2012, when it was increased to 3,000 metric tons. Goldman's warehouses have treated the LME minimum as a maximum, shipping no more than the minimum. In addition, Metro formed a single exit line for all 28 of its Detroit-area warehouses combined, and decreed that the daily minimum applied to that single exit line. Now, the merry-go-round deals increased the length of the queue and clogged the exit line. In most of the merry-go-round deals, the metal owner agreed to cancel warrants on a large amount of aluminum and put that metal in the exit queue. When the owner got to the front of the line, it loaded out its metal onto trucks, but the metal did not leave the Metro system. Instead, the trucks moved the aluminum to a nearby Metro warehouse, and the metal owner eventually re-warranted the metal. In exchange, Metro paid millions of dollars to the metal owners--once when they canceled the warrants and again when they re-warranted the metal in another Metro warehouse. It is important to understand that the first of these deals, reached with Deutsche Bank just 7 months after Goldman bought Metro, came after Deutsche Bank simply asked for a discount on rent for its aluminum. Nothing prevented Metro from simply giving such a discount. Instead, the warehouse proposed the convoluted merry-go-round, which effectively gave Deutsche Bank the discount it wanted, but with the added benefit to Metro and Goldman of adding 100,000 tons of aluminum to the exit queue. Metro used this same model in several subsequent deals. In some deals, metal was loaded onto a truck and shipped a mere 200 yards to a different warehouse building. Most of the deals involved shuffling virtually identical loads of aluminum among multiple warehouses, which is why a forklift operator called it a ``merry-go-round of metal.'' Because each deal involved between 100,000 and 265,000 metric tons of aluminum, loaded out at 1,500 and then 3,000 metric tons a day, the net effect was that each deal added weeks or months to the queue. The lengthening queue had a number of effects. First, it boosted revenue at Goldman's warehouses--the more metal stored in the warehouses, the more rent and fees. The longer queue also affected aluminum prices. The ``all- in'' price that consumers pay for aluminum has several components, but the two major components are the LME Official Price, set on LME's exchange, and a regional premium that reflects local variations in storage and delivery costs. The regional premium in the United States is known as the Midwest Aluminum Premium. And as the chart shows, Exhibit 1f,\1\ as the queue in Metro's Detroit-area warehouses increased, so did the Midwest Premium. As the queue increases, the premium increases. --------------------------------------------------------------------------- \1\ See Exhibit No. 1f, which appears in the Appendix on page 821. --------------------------------------------------------------------------- Most market participants believe that a higher Midwest Premium means higher all-in prices, which means Goldman's warehouses are using a tactic that earns the bank higher rents at the expense of a wide range of businesses that use aluminum. Those businesses include Austal, a company that builds combat ships for our Navy and which told the Subcommittee that the effects of rising Midwest Premiums have forced it to take costly steps that damage not just the company, but cost U.S. taxpayers. Goldman argues that these market participants are incorrect, and that the total price of aluminum was unchanged by the merry-go-round deals and the longer queues. It argues that as the Midwest Premium rises, the LME price falls. That is the Goldman argument. The Midwest Premium rises, the LME price falls, so that the all-in price remains unchanged. Again, that is not what other market participants say. But even if that were true, Goldman's warehouses are still engaged in unacceptable manipulation. As the queue-inflated Midwest Premium has risen, it has taken up an increasing share of the all-in price for aluminum--from just 6 percent of the all-in price in 2010 to over 20 percent this year. That increase means that the LME price has fallen as a percentage of the all-in price, making LME futures a less effective tool to hedge price risk. Now, in addition to assessing supply and demand, aluminum users must try to hedge just how long a load-out queue Goldman's warehouses can engineer. What's more, if Goldman's theory is correct and the LME price goes down as the premium goes up, Goldman has the ability to manipulate the LME price by manipulating the Midwest Premium, and then to make trades taking advantage of that manipulation. Goldman's ability to influence any portion of the price for a key component of the industrial economy is simply unacceptable. While the LME has rules designed to prevent a situation where a warehouse could share valuable confidential information with traders, those rules are porous. Under LME rules, Metro shares confidential information with more than 50 Goldman employees, including top executives who manage Goldman's commodities trading, while also sitting on Metro's Board of Directors. The Metro Board, which has consisted exclusively of Goldman employees, reviewed and approved all significant business decisions at Metro, including the merry-go-round deals. In other words, a warehouse strategy that materially affected the aluminum market was approved by executives of a bank uniquely positioned to trade profitably on the effects of that strategy. Think about the opportunity for Goldman to affect the premium and price at the same time it was trading in that metal. In fact, the information to which Goldman's top commodities executives have access through Metro is so sensitive and valuable that LME will not publish it. In a 2013 report, LME said it does not publish detailed information on warehouse stock and queues because ``the danger is that those merchants and trading houses with the most well-staffed analytical capabilities will take advantage of the availability of data to derive a trading advantage.'' It is hard to think of a trading house that better fits that description than Goldman Sachs. There is little doubt that if we were talking about the stock market, rather than commodities transactions, the use of inside information that affects prices would be strictly prohibited. But until passage of Dodd-Frank, there were no legal prohibitions on using valuable non-public information to trade commodities, and even now, regulators' authority to stop such abuse is untested. So, the potential for abuse is great, and the only protections against abuse are company policies against sharing information. Given the recent history of banks improperly sharing information to manipulate electricity, LIBOR, and foreign exchange rates, the reliance on voluntary policies at companies that have an economic interest in the opposite direction is not enough protection for consumers, to put it mildly. This concern is especially relevant given Goldman's rapid increase in aluminum trading after it acquired Metro. After buying Metro in 2010, Goldman's physical aluminum stockpile grew from less than $100 million to, at one point, more than $3 billion, a 30-fold increase. This stockpile also allowed Goldman itself to add to the queue at its Metro warehouses, where in 2012, Goldman canceled warrants on about 300,000 metric tons of its own aluminum, adding months to the queue. Goldman made a series of massive aluminum trades at the same time its warehouses' dealings were pushing the Midwest Premium higher, including trades in 2012 involving more than 1 million metric tons of metal. Goldman contends that it adheres to rules preventing the sharing of useful information between its warehouses and its traders. That contention is hard to square with the bank's stated justification for its involvement in physical commodities. In a 2011 presentation to Goldman's board, its executives wrote that Goldman's commodities division would achieve higher value ``if the business was able to grow physical activities, unconstrained by regulation and integrated with the financial activities.'' Goldman's goal, in the words of its own executives, is to profit in its financial activities using the information that it gains in the physical commodities business. All of these issues and concerns come back to the principle of separating banking and commerce. Banks are not supposed to be running commercial businesses like warehouses, natural gas facilities, or power plants. Those activities open the door to higher prices and greater uncertainty for businesses and consumers, and to price manipulation and trading based on information not available to other market participants. To restore confidence in commodity markets as well as reduce risk in the banking system, it is time to reduce bank involvement with physical commodities and to prohibit the use of non-public information in transactions involving commodities that the banks themselves control. Our Report offers a number of ways to address the issue, and the Federal Reserve's possible rulemaking provides a needed opportunity to address these problems. Today we will explore banks' physical commodity activities and the dangers that result. Tomorrow we will hear from additional experts and regulators. And now I turn to my partner in this bipartisan investigation, and my partner in so many other efforts over the years, Senator McCain. OPENING STATEMENT OF SENATOR McCAIN Senator McCain. I thank you, Mr. Chairman, and before I begin, I want to say what an honor and privilege it has been to serve alongside you in this Subcommittee. Your tireless efforts and steadfast dedication to exposing misconduct and abuse by financial institutions and government regulators have set a new standard for thoughtful and thorough congressional investigations. Whether the topic was the 2008 financial crisis, Swiss banking secrecy, or JPMorgan's ``London Whale'' debacle, professionals in the industry and the public at large knew that they could count on you to get to the bottom of it with authoritative reports and hearings. Your tenacity in uncovering wrongdoing sparked significant changes in the financial sector. I also commend you on zealously and effectively pursuing your investigations in a way that has furthered this Subcommittee's long-standing tradition of bipartisanship. We may have had our disagreements, but we did not let them get in the way of finding common ground in most cases. While your retirement may come as a relief to some of those on Wall Street, your patience, thoughtfulness, and commitment to bipartisanship will be deeply missed on this Subcommittee, on the Armed Services Committee, and in the U.S. Senate. Today's hearing explores the way in which major banks produce, store, and sell physical commodities like aluminum, natural gas, and uranium. It sheds light on the little-known yet large role that banks play in the commodities markets and the risks inherent in those activities. This lack of insight into the banks' commodities operations raises concerns about, among other things, potential market manipulation and excessive risk that could, in extreme circumstances, lead to taxpayer bailouts. This investigation has shown how, through their commodities activities, some of the country's largest financial institutions have taken on arguably excessive levels of risk, raised suspicions of market manipulation, and potentially gained unfair trading advantages. JPMorgan, for example, paid fines for energy price manipulation relating to its dozens of power plants, I believe $410 million. Morgan Stanley has entered the oil industry and even supplies several airlines with jet fuel at airports across the country. Goldman Sachs has uranium holdings and manages coal mines in Colombia. In each of these operations, there are dangers of toxic spills, deadly explosions, and other disasters. These are not the risks we normally associate with banks, whose primary role should be focused on more traditional banking activities. The American people are all too familiar with costly accidents in these industries. For example, BP incurred around $40 billion in damages resulting from the Deepwater Horizon oil spill. Imaging if BP had been a bank. The losses and the liability resulting from the spill would have led to the bank failing and another round of taxpayer bailouts. Even if a bank survived such a catastrophe, the resulting financial shock might hurt ordinary investors and pension holders. Similarly, inappropriate activities undertaken by financial institutions in commodities markets could lead to unfair trading advantages and conflicts of interest for the banks, and artificially higher prices for consumers. Mr. Chairman, I think you have just outlined that some of the activities have already led to artificially higher prices for consumers, including aluminum. Little is known about these activities, and even less has been done to combat some of the biggest concerns about risk and manipulation. This warrants oversight by Congress and financial regulators as well as potential changes to laws and regulations, to curb the dangers to the economy and halt unfair practices. While Chairman Levin has recommended, and our witnesses may offer, some potential solutions in our hearing today, I think we should be mindful of unintended consequences. But these concerns are serious, and, again, part of it goes back to our failure to commit after the catastrophe of 2008 that no institution would ever be too big to fail. I do not believe that anyone in America believes that these three financial institutions before us, that we have reduced them to the state where they are not too big to fail. I thank you, Mr. Chairman. Senator Levin. Thank you very much, Senator McCain, for your warm comments, for our long friendship and collaboration on so many matters, for your defense of this country, and your taking the gavel at the Armed Services Committee is surely going to be a very important moment in the future of this country and that committee. And your work and your staff's work on this Subcommittee has been essential to whatever successes we have had in terms of our investigations and recommendations. So thank you very much. We are going to have a number of votes today at 2 o'clock. There could be up to five votes, and my plan is to recess the hearing during those votes, which will also allow people time to have lunch. That is not what we planned for, but that is what the Senate schedule has brought us to. So it is not certain but it is likely that we will adjourn for about 90 minutes--it could be 60 to 90 minutes--at around 1:45. We will now call our first panel of witnesses for this morning's hearing: Christopher Wibbelman, President and Chief Executive Officer of Metro International Trade Services LLC, Allen Park, Michigan; and Jacques Gabillon, Head of the Global Commodities Principal Investment Group of Goldman Sachs & Co., London, England. Gentlemen, I appreciate both of you being with us this morning. We look forward to your testimony, and as you, I think, are already aware of, all witnesses testifying before this Subcommittee are required to be sworn, so I would ask you now to raise your right hand as I administer the oath. Do you swear that the testimony that you will provide to this Subcommittee will be the truth, the whole truth, and nothing but the truth, so help you, God? Mr. Wibbelman. I do. Mr. Gabillon. I do. Senator Levin. Under our timing system today, at about 1 minute before a red light comes on you will see the lights change from green to yellow. That will give you the opportunity to conclude your remarks. And your written testimony will be printed in the record in its entirety. We would appreciate your limiting your oral testimony to 5 minutes. And, Mr. Wibbelman, we will have you go first. TESTIMONY OF CHRISTOPHER WIBBELMAN,\1\ PRESIDENT AND CHIEF EXECUTIVE OFFICER, METRO INTERNATIONAL TRADE SERVICES LLC, ALLEN PARK, MICHIGAN Mr. Wibbelman. Thank you, Chairman Levin, Ranking Member McCain, and Members of the Subcommittee. My name is Chris Wibbelman, and I am the CEO of Metro International Trade Services. I have been with Metro since it was founded in 1991 as a startup company in Michigan, and I have served as its CEO since 2006. --------------------------------------------------------------------------- \1\ The prepared statement of Mr. Wibbelman appears in the Appendix on page 139. --------------------------------------------------------------------------- I was born and raised in Detroit. I attended Detroit public schools and graduated from Michigan State University. I have worked my entire life in the greater Detroit area, managed and ran several businesses. I have also served as Manager of Small Business Development for the Greater Detroit Chamber of Commerce. Metro operated LME warehouses since 1992 when we secured approval for Detroit to serve as an eligible LME delivery point. Much of Metro's growth occurred following the global financial crisis when worldwide consumption of aluminum declined and the demand for storage of metal increased. Starting in 2008, Metro purchased or leased 5.1 million square feet of warehouse space, much of which was unused industrial buildings. The process of renovating the industrial space and installing rail track and rail sidings created jobs when many Detroit residents were out of work or being laid off. The first thing to understand about the aluminum warehousing business is that it is driven by broader economic forces. Given the cyclical nature of this business, from 1994 to 2001, Metro had virtually no aluminum whatsoever in its Detroit warehouses. During that period, we managed the business efficiently and remained committed to Detroit. And when the aluminum consumption dropped beginning in 2008, Metro was in a position to respond rapidly to the needs of aluminum producers. I believe that we were instrumental in allowing North American smelters to keep producing aluminum during the period of collapsing demand. The LME rules govern the way in which all LME warehouses are operated. These rules are established by the LME and not the warehouse companies. One such rule is the amount of metal that the LME warehouses must load out each day. When the new LME rule increasing the load-out rate was suspended by a court in the United Kingdom, Metro announced that it would comply with the rule voluntarily, even though it was not required to do so. More aluminum has been loaded out of Metro's Detroit warehouses than from any other warehouse company in the United States. In 2014 alone, we expect to load out approximately 600,000 metric tons of aluminum. The Subcommittee's Report makes repeated references to aluminum ``queues,'' and it is important to understand that all of the aluminum stored in and out of aluminum warehouses, 80 percent of it is not subject to any queue. Consumers can purchase aluminum from producers or any owner of aluminum that is stored in or out of the LME system, and that metal is available for immediate outbound shipment. It is also important to understand two other aspects of the queues. First, they are the result of independent decisions of owners of metal to realize the relative value of that metal compared to other metal. In order to realize that value, the owners must remove the metal from Metro's LME warehouse. Second, metal owners pay rent for all metal in Metro's warehouses, regardless of whether it is in a queue or not. Metro's revenues are not dependent on the length of queues. The Subcommittee's Report also refers to the July 2013 New York Times article you mentioned, which described supposed ``merry-go-round transactions'' involving the movement of metal off-warrant from one warehouse to another. As the article itself acknowledged, there is no suggestion that the activities violate any laws or regulations. Metro offered its customers the opportunity to store metal off-warrant in a different Metro warehouse. Such customers had various other options, including storing their metal with competing companies, many of which have warehouses near to Metro's. Metro offered these off-warrant transactions to compete for storage of their metal once it was loaded out and it was no longer part of the LME system. But it was always up to the owner, not Metro, to decide what to do with the metal. The metal at issue in these relatively few transactions was loaded by Metro at the owner's instructions onto a truck, issued a bill of lading, and moved to another location at the owner's direction. Once the owner made the choice, the LME rules required that Metro follow the owner's instructions and treat the metal as loaded out and reduce its LME inventory stocks accordingly. The fact that the metal owner moves the metal between Metro warehouses in the Detroit area is no different under the LME rules than if it moves to an equally close non-Metro warehouse. I appreciate the opportunity to provide this information about Metro's warehouse business, and I hope it will contribute to the Subcommittee's understanding. Senator Levin. Thank you very much, Mr. Wibbelman. Mr. Gabillon. TESTIMONY OF JACQUES GABILLON,\1\ HEAD, GLOBAL COMMODITIES PRINCIPAL INVESTMENT GROUP, GOLDMAN SACHS & CO., LONDON, ENGLAND Mr. Gabillon. Chairman Levin, Ranking Member McCain, and Members of the Subcommittee, my name is Jacques Gabillon. I lead Goldman Sachs' Global Commodities Principal Investment Group, or GCPI, and I also serve as chairman of the board of directors of Metro. --------------------------------------------------------------------------- \1\ The prepared statement of Mr. Gabillon appears in the Appendix on page 142. --------------------------------------------------------------------------- In early 2010, GCPI believed that the Metro warehouse was a sound investment because the global recession had reduced worldwide demand for aluminum and would increase demand for storage. It was a good investment. At the time of the investment, customers had already deposited over 800,000 tons of aluminum at Metro, and we believed that the surplus condition would persist. Consequently, Metro was well positioned to continue to realize this demand for storage. Metro's board of directors sets the general strategy and conducts oversight in keeping with standards of good corporate governance and the requirements of the Bank Holding Company Act. The board has always included people from the firm's control functions, including the Compliance Department. As you know, Metro is subject to the rules of the LME, including the minimum amount of metal required to be loaded out of warehouses each day. Often the dynamics of this LME system are mistaken for the broader aluminum market, which supplies most consumer products. As a starting point, the price negotiated between many sellers and buyers of aluminum in the United States is commonly referred to as the ``all-in price.'' The difference between this all-in price and the price for an LME warrant is referred to as the ``Midwest Physical Premium.'' But one thing is clear: The all-in price has actually fallen substantially since 2008. Consequently, any suggestion that end users are paying more for aluminum because of a higher premium is simply not supported by the facts. Like every other market, the price of aluminum is established through supply and demand, and those trends have been unmistakable. There has been a consistent surplus of aluminum since 2008, resulting in a large volume that has been placed in storage. That is why there has never been a shortage of aluminum. In addition, there are large quantities of aluminum stored outside the LME system. So together with non-queue aluminum, there is approximately 9.6 million tons of aluminum to be sold for immediate delivery to any user. I would like to briefly address the issues of queues. To begin with, the length of the queue to remove metal from Metro's warehouse is not the result of any action by either Goldman Sachs or Metro. General economic confidence and availability of credit improved, making off-warrant storage a more attractive alternative. This occurred not only in Detroit, but also in another major city for metal warehousing, Vlissingen in the Netherlands. One more thing occurred at the time. The LME changed its rule to double the minimum load-out requirement from 1,500 to 3,000 tons per day. The Subcommittee should know that when the LME doubled the minimum load-out requirement, the result was actually longer, not shorter, queues. And most importantly, based on the reports we have provided to the Subcommittee, these queues do not drive the all-in price that consumers pay. On a related issue, we have provided a significant amount of information to the Subcommittee on the issue of incentives. Operators may offer an up-front payment on future rent collections to customers who place metal on warrant in their warehouses. In other instances, operators offer discounted rent to customers who agreed to store their metal for specific durations. These incentives are similar to those offered by landlords, such as offering one month's free rent to attract a tenant or reducing rent for a tenant who signs a long-term lease. Metro has offered both of these incentives, consistent with the LME rules and industry practice. The inducements that have been offered result from arm's-length negotiations between Metro and a sophisticated customer. Finally, I will briefly conclude with a description of the information barriers that exist between Goldman Sachs and Metro. The LME rules require that an information barrier be established between a warehouse company and affiliated trading entities. Goldman Sachs has such a barrier in place which not only meets, but exceeds, the LME's requirements. We take this issue very seriously. For example, much of the material that Metro generates and distributes to its board is not actionable for a trader and, in any event, is dated and sanitized to remove the names of counterparties. Regular reviews by Goldman Sachs personnel and outside auditors have not found a single instance where confidential Metro information went to the metals trading personnel of Goldman Sachs. Mr. Chairman and Senators, in the many hours we have spent with the Subcommittee staff, we have described the market fundamentals that dictate price and availability, and I look forward to continuing that discussion today. Thank you. Senator Levin. Thank you very much. First, Mr. Wibbelman, you are the Chief Executive Officer of Metro. Mr. Gabillon, you were for most of the period an executive in Goldman's Global Commodities Principal Investment Group, and you were chairman of Metro's board of directors. So in the very first board meeting, after Goldman bought Metro in 2010, the board discussed the incentives that Metro would pay to attract more aluminum to its warehouses in Detroit. If you look at Exhibit 1b,\1\ that is a chart which was sent to us by Goldman's legal counsel on the total amount of freight incentives or allowances paid by Metro in each year from 2010 to 2013. You will see that each year after Goldman acquired Metro, Metro paid more and more cash incentives to attract aluminum to its Detroit warehouses, going from about $36 million to over $128 million. That does not count expanding rent discounts and other incentives, so that is an increase of about 350 percent over just a few years for freight allowances. --------------------------------------------------------------------------- \1\ See Exhibit No. 1b, which appears in the Appendix on page 817. --------------------------------------------------------------------------- Are those figures accurate? Were those allowances and subsidies increased as shown on that chart? Mr. Gabillon. I do not recognize exactly the numbers. Senator Levin. Are they approximately right? Mr. Gabillon. But the trend is correct and is a reflection of the evolution of the aluminum markets. Senator Levin. Now, Mr. Wibbelman, you told the Subcommittee that after Goldman acquired Metro, you generally had to run all your major decisions by Metro's board or a board subcommittee. That was made up totally of Goldman people. Did you consult with Mr. Gabillon and the board before increasing Metro's incentives? Mr. Wibbelman. So, Senator, I had a level of authority for incentives at various time periods, and that would be adjusted by the board of directors. And then as circumstances changed, that would be occasionally reviewed from time to time or it would be--we would make a specific request on a specific case basis, and it would be either approved by the Commercial Subcommittee or it would---- Senator Levin. Of the board? Mr. Wibbelman. Of the board, or it would not. Senator Levin. So as to whether you consulted with Mr. Gabillon and the board before increasing Metro's incentives, the answer, I take it, is generally yes, although you had some authority between those approvals. Is that correct? Mr. Wibbelman. Yes. Senator Levin. So basically it was a joint decision to go ahead with this program and these incentives, is that correct? Mr. Wibbelman. Well, Senator, if I might, you know, the market itself at that point in time was, you know, incredibly dynamic and unique, and so, you know, it was--at that point in time, we were evaluating really a wave of surplus metal that was making itself available to us. And Metro was trying to respond operationally in order to be able to receive it all, and that is---- Senator Levin. You were giving incentives to bring more into your warehouse. Is that correct? Mr. Wibbelman. Incentives have been a part of our business for the 23 years---- Senator Levin. I understand, but the amount of the incentives dramatically increased. Is that correct? Mr. Wibbelman. Because the magnitude of the metal also increased. Senator Levin. Did the amount of the incentives dramatically increase? Mr. Wibbelman. They increased over the full 5-year period of time. Senator Levin. As shown on that chart? Mr. Wibbelman. Yes. Senator Levin. And that was a joint decision, was it, between you and the board and the board subcommittee? Mr. Wibbelman. Generally, yes. Senator Levin. OK. Now, if you look at Exhibit 1d,\1\ this is a list of Metro board members, and this was supplied to us by Goldman's legal counsel. Are these all Goldman employees? Is that correct? --------------------------------------------------------------------------- \1\ See Exhibit No. 1d, which appears in the Appendix on page 819. --------------------------------------------------------------------------- Mr. Wibbelman. Not currently anymore, no. Senator Levin. They were? Mr. Wibbelman. At the time of their service, yes. Senator Levin. And, Mr. Gabillon, did Mr. Wibbelman talk to you personally as well as to other board members about increasing the amount of freight incentives that Metro would pay to attract metal to its Detroit warehouses? Did you have personal conversations with Mr. Wibbelman about that? Mr. Gabillon. Yes, we had many conversations in the context of the board, yes. Senator Levin. About that subject? Mr. Gabillon. Yes. Senator Levin. And then the board members approved these increased amounts generally. Is that correct? Mr. Gabillon. I think there were many times where we did not approve an increase. Senator Levin. You disapproved an increase? Mr. Gabillon. Yes, there were many times where we kept the level of approval constant. Senator Levin. OK. But when there were increased amounts, the board generally approved them. Is that correct? Mr. Gabillon. Yes, that is correct. Senator Levin. Now, we are going to spend some time talking about LME warrants, queues, and so I want to explain this as clearly as I can. The LME is the world's largest metals exchange, and when you buy a future contract on the LME, in a fixed period of time you can settle the contract by paying money and taking delivery of warrants, which are documents that convey actually legal title to specific lots of metal that are stored in an LME-approved warehouse. In aluminum, these lots of metal are 25 metric tons or about 2,200 pounds. And when an owner of the metal wants to take physical possession of the metal, the owner has to cancel the warrants and get in the exit line or queue to leave the warehouse. But the LME warehouses only have to load out a specific amount of metal every day. For the largest warehouses, it used to be 1,500 metric tons. It was raised to 3,000 metric tons. So for warehouses that store hundreds of thousands or millions of tons, if an owner of a lot of aluminum cancels his warrants at once, it can dramatically increase the queue, making everyone else stay in the warehouse and continue paying rent longer. But that is not the only thing. As we will learn more about later, the length of that queue impacts the prices of metal and related financial products. It is highly correlated to the premium, and that premium, when added to the LME price, is the so-called all-in price. Mr. Wibbelman, beginning shortly after Goldman bought Metro and over the next few years, Metro entered into what became six deals that involved owners of metal being paid incentives by Metro for waiting in the queue, moving metal from one Metro warehouse to another, and re-warranting. And I am going to call them ``merry-go-round deals.'' That is what a forklift operator called them. Mr. Wibbelman, you told the Subcommittee that Metro had never done deals like that prior to being acquired by Goldman. Is that correct? Mr. Wibbelman. Yes, but I do not think it was anything to do with Goldman as to why that was not the case, Senator. Senator Levin. I understand. But before you were acquired by Goldman, you never entered deals like that. Is that correct? Mr. Wibbelman. Yes, but there was never a market dividend like that either. Senator Levin. OK. Now, before doing this new type of deal, did you consult with Mr. Gabillon or others at Goldman? Mr. Wibbelman. Yes. Senator Levin. And did you consult with Goldman employees on Metro's board before finalizing each of these deals? Mr. Wibbelman. Yes. Senator Levin. So it was a joint decision to go ahead. Mr. Wibbelman. Yes, I think it---- Senator Levin. Is that fair to say? Mr. Wibbelman. I would say that there was an alignment of understanding about the deals. Probably some of those deals I might have had the authority to execute without formal written authority, and other ones I did not, but all of them were thoroughly vetted. Senator Levin. And jointly decided upon. Is that correct? Mr. Wibbelman. Yes. Senator Levin. OK. Now, this is what happened on 1 day, December 27, 2013. Workers at eight of Metro's warehouses were rapidly shuffling about 5.5 million pounds of aluminum between Metro's warehouses. Workers at a warehouse in Detroit on East McNichols Road were busy shipping out ten truckloads of aluminum, which is more than 860,000 pounds, to a warehouse on Lynch Road. The Lynch Road warehouse workers were busy shipping 17 truckloads of aluminum, totaling about 1.4 million pounds, right back to East McNichols Road. Now, if that were not enough, three other warehouses, on Lafayette Street, Pennsylvania Road, and 22d Street, shipped millions of pounds of aluminum to three other nearby warehouses located at East Nine Mile Road, Ecorse Road, and West Jefferson. Now, when you look at these deals and look at the specifics, this is what happened. Look at Exhibit 1c.\1\ This was provided by Metro's legal counsel. It shows that as of January of this year, over 600,000 metric tons of metal were moved between Metro warehouses in Detroit. All of those 600,000 tons, if you look at Exhibit 1c, came from just those six deals that you identified. Is that correct? First of all, look at Exhibit 1c and do you agree--this was provided, again, by Metro legal counsel--that all 600,000 of those tons came from just those six deals that we have talked about. Is that correct? --------------------------------------------------------------------------- \1\ See Exhibit No. 1c, which appears in the Appendix on page 818. --------------------------------------------------------------------------- Mr. Wibbelman. Yes. Senator Levin. Now, the merry-go-round deals required Metro to organize and pay for thousands of truck shipments between its own warehouses, pay millions of dollars in incentives to its warehouse customers. We have details on the incentive payments for just two of those six deals, but those invoices alone show Metro owing two warehouse customers, Red Kite, which is a hedge fund, and Glencore a total of about $37 million. And Exhibit 22a\2\ is an invoice summary of just the most recent two deals. --------------------------------------------------------------------------- \2\ See Exhibit No. 22a, which appears in the Appendix on page 1002. --------------------------------------------------------------------------- Can you tell us first, Mr. Wibbelman, how much Metro paid for the first four deals? We know it was about $37 million in subsidies and incentives for the two that I have mentioned, but just for the first four, do you know what that total is? Mr. Wibbelman. I do not know what that total is, Senator. Senator Levin. The two deals alone that we are talking about required 6,500 truckloads of aluminum to be shuttled between Metro's Detroit warehouses. Do you know how many thousands of trucks Metro had to arrange and pay for under the previous four deals, Mr. Wibbelman? Mr. Wibbelman. I do not know that, Senator. Senator Levin. That is OK. These deals were so important that they were taken to Metro's board of directors for approval. Now, they were not in a formalized contract. Is that correct? These deals did not result in a formalized contract? Mr. Wibbelman. Overwhelmingly, none of our deals takes place on a formal contract. Senator Levin. All right. There was an effort at a formal contract, was there not, with Deutsche Bank? Mr. Wibbelman. If a customer wants to have a contract, we will look at it and talk about whether we need to have one or not. But our deals are settled incrementally over time. Senator Levin. That is fine. Mr. Wibbelman. So we tend not to need them. Senator Levin. And Deutsche Bank wanted one? Mr. Wibbelman. They provided one. Senator Levin. And signed it? Mr. Wibbelman. And signed it. Senator Levin. And you did not? Mr. Wibbelman. I do not believe it was countersigned. Senator Levin. And why? Mr. Wibbelman. I think they just decided they did not need it. Senator Levin. Oh, they did not want it, Deutsche Bank? Mr. Wibbelman. I do not have that recollection at this time. It was not a material component of whether the deal took place. We knew we would not have had to make any of our payments if it had not been executed like it was supposed to. Senator Levin. Now, we only have the details on the last two of these deals, but, again, the six deals involved Metro arranging and paying for thousands of trucks to move over 600,000 metric tons of aluminum from one warehouse to another. In one case, the aluminum was moved from one warehouse to another about 200 feet away. Now, was the point of all these truckloads shifting metal from one warehouse to another Metro warehouse to enable Metro to claim it was meeting the LME daily minimum load-out rule that said that a warehouse had to load out a minimum of 1,500 pounds, later 3,000 pounds a day, while at the same time ensuring that virtually no metal actually left the Metro system? Mr. Wibbelman. Well, Senator, I mean, it starts with the-- -- Senator Levin. Was that the point of it, is my question. Mr. Wibbelman. I am trying to answer. It starts with the recognition of the customer that the metal that is available within the Metro system is of relatively better value than any other metal it can purchase. And, typically, for example, in the first deal that you mentioned, the owner wanted to own metal and finance it for a duration of time. And the way for them to capture that was to own the metal, and once they owned the metal, the way for them to protect their value was to put it in the queue and plan to take it out. Senator Levin. They could have continued to own the metal and leave it in the warehouse. Is that correct? Mr. Wibbelman. They could have, but it would have cost them more, and so they chose not to do that. Senator Levin. And you gave them a subsidy to go through this rinky-dink merry-go-round system. They could have---- Mr. Wibbelman. Well, Senator, we do not---- Senator Levin. You could have given them a subsidy, a discount, and leave it in the warehouse, could you not? Mr. Wibbelman. Well, you can--Senator, we are a commercial business, right? Senator Levin. Is that right? You could have given them a discount and left it in the warehouse. Mr. Wibbelman. Yes. Senator Levin. But you moved it to another warehouse, sometimes 200 feet across, and the result of that was it stays in your warehouse but it also lengthens the queue. Were you aware of the fact that the queue would be lengthened when they did what you arranged for them to do? Mr. Wibbelman. We did not arrange for it, right? The customer chose to do it---- Senator Levin. No, but the customer was also paid to do it. Mr. Wibbelman. The customer was paid---- Senator Levin. By you. Mr. Wibbelman. In the event that they moved it to another warehouse and then chose to warrant it later. They did not have to make that choice, and they did not. Senator Levin. They were paid by you, were they not, they were paid by you to keep that in your warehouse? Mr. Wibbelman. That was a choice they made. Senator Levin. Would they be penalized if they did not do it under the contract? Mr. Wibbelman. Well, it was a contract where they--what they did is they, by freedom of contract, chose to agree on an economic set of conditions. Senator Levin. And under that contract, was there a penalty if they did move to another warehouse other than yours? Was there a penalty? Mr. Wibbelman. Well, we presumed that we would get a revenue stream in order to provide the incentives we provide, and if they chose a different route, they were effectively going to refund us back that amount. Senator Levin. Mr. Wibbelman, I am asking you a very direct question. You gave them an incentive to, first of all, de- warrant, right? They would have to then go to the head of the queue, and then you gave them an incentive in a contract, in an agreement to go to another warehouse, sometimes a few hundred feet away, and join another queue. Is that correct? Mr. Wibbelman. No, because they had many options, Senator. They had the option---- Senator Levin. Not under the contract they did not. Mr. Wibbelman. Yes, they did. They had the option---- Senator Levin. They could break the contract. Mr. Wibbelman. They can break the contract. Senator Levin. OK. That is not much of an option for most business people to break---- Mr. Wibbelman. That was the---- Senator Levin. Wait a minute. Let me finish. That is not much of an option for most business people. You say they had the freedom to break the contract. You entered a contract which, if they lived up to it, required them to move, sometimes a few hundred feet, their metal to another Metro warehouse. You paid them to do that, and then there was a penalty if they did not under that contract. They had the freedom to break the contract. Most business people do not consider that a choice. Mr. Wibbelman. Well, Senator, they set the contract up in the beginning---- Senator Levin. Did you not? Were you not a party to that contract? Mr. Wibbelman. Of course. I am one part. The other party is the counterparty. Senator Levin. Of course. Mr. Wibbelman. And so that was the agreement---- Senator Levin. But under the contract--let us be clear--you insisted in that contract that they would pay a penalty if they did not put their metal into another Metro warehouse. You paid them a subsidy to do that, and there was a penalty if they did not do that. Is that correct under that contract? Mr. Wibbelman. That was correct, but it was also in response to costs that we incurred or revenues that we did not receive. So we were effectively trying to get a reimbursement for things that we would otherwise have been able to receive or expenditures were made. Senator Levin. And you could have given them an incentive to stay in the original warehouse, could you not? You could have kept them there with a discount? Is that correct? Mr. Wibbelman. Yes, we could---- Senator Levin. You were allowed to do that. Mr. Wibbelman. We could have given them anything, but commercially, as a business, that is not what we choose to do. Senator Levin. No. But you chose instead to do this in a way which, will you agree, lengthened the queue? Mr. Wibbelman. So we---- Senator Levin. I am just asking you. Was the effect of this to lengthen the queue? Mr. Wibbelman. Senator, anyone that cancels a warrant in a warehouse for that moment adds to the queue. But it could have been any--remember, there are tons of other warehouses. Senator Levin. I am just getting a direct answer from you, if I can. The effect of this arrangement was that the queue was lengthened. Is that correct? It is a simple, direct question. And you are under oath. Was the effect of that to lengthen the queue? Mr. Wibbelman. If they chose to cancel their warrants----- Senator Levin. Not if they chose. Did the contract provide---- Mr. Wibbelman. Yes, but if they chose that, they had to actually obtain warrants and cancel them, and that was something that was their choice. Senator Levin. This is warranted metal in your warehouse. Mr. Wibbelman. Yes, but the warrants are freely floating title documents. Senator Levin. Of course. Mr. Wibbelman. They have to go find one, right? Senator Levin. I understand. Mr. Wibbelman. And once they find it, they have to actually cancel it. Senator Levin. I want to get a straight answer from you, if I can. Mr. Wibbelman. I am trying to give you them. Senator Levin. OK, but let me go through this. You entered into a contract which required the counterparty, is that not correct--if they lived up to the contract---- Mr. Wibbelman. Yes, if they chose to. Senator Levin. If they chose to live up to a contract, do not most people you deal with honorably live up to their contract? Mr. Wibbelman. But it was always their option. Senator Levin. To cancel--to not live up to the contract? Mr. Wibbelman. It was always if you do it, then you will get the incentive. Senator Levin. The contract you entered into required them to immediately cancel their warrants. Is that correct? Mr. Wibbelman. I do not recall that it was a requirements contract. I recall it was an optional contract, an option. Senator Levin. Well, we will get into the words of the contract and which you did not want to put in writing, but we do have one contract that is in writing. And I just want to sum--just get to the bottom line. The contract which you entered into required them, if they lived up to the contract-- -- Mr. Wibbelman. Which they did not have to do, right? Senator Levin. Let me just finish this. If they live up to the contract, they were required to immediately cancel the warrants, move the metal to another warehouse, and the result of that is to lengthen the queue. Is that accurate? If they lived up to the contract. Mr. Wibbelman. If they made all those choices, which they did not have to make by the contract, in my recollection. Senator Levin. If they lived up to the contract, is my question. Mr. Wibbelman. My recollection is that the contract was an option contract where they had the option to do it. Senator Levin. The option to enter the contract? Mr. Wibbelman. They had the option--they never had to cancel the metal in the first place. Senator Levin. OK. Senator McCain. Senator McCain. Remarkable. Mr. Wibbelman, it used to take 40 days for Metro to remove aluminum from its warehouses for its clients. Now it takes over 600 days. How do you explain that? Mr. Wibbelman. Senator, that is a recognition of the relative value of the metal that is in Metro's warehouses compared to any other metal that exists in the LME system or with any other private owner in the world, and that is--what happens is those warrants are canceled when someone perceives it as being a value, a relative value. Senator McCain. That has to do with the time that it takes to remove aluminum from a warehouse? Mr. Wibbelman. Well, the LME system, Senator, is a seller's choice contract. So, in other words, if someone sells metal, they get to pick which warrant that they want to surrender in satisfaction of that contract. Senator McCain. Someone wants Metro to remove aluminum from its warehouse, a client does. Now it takes over 600 days, and it used to take 40 days. And you are saying that has to do with the nature of the contract? Mr. Wibbelman. No. Well, I am saying that it is a reflection of the fact that the London Metal Exchange price moves in relation to the relative value of the available warrants that are freely floating in the market. Senator, if I can explain---- Senator McCain. Mr. Gabillon, Metro's warehouses are approved by the London Metal Exchange. Isn't it true that LME raised concerns about the merry-go-round scheme in your warehouse operations? Is it true that they raised concerns about it? Mr. Gabillon. First, Senator, if I may, we do not call them ``merry-go-round transactions'' for a very precise reason. We refer to them as ``off-warrant transactions'' because that is what Metro offers to its customers. Senator McCain. I am just asking, is it true or not true, yes or no, that LME raised concerns about your warehouse operations? Mr. Gabillon. They started an investigation on a very specific point, yes. Senator McCain. Mr. Gabillon, over 50 Goldman employees received confidential information about Metro's warehousing operations. So, therefore, they have access to commercially valuable non-public information. And Goldman, as we know, has other interests, including trading. What procedures does Goldman have or do you have to ensure that its traders do not have access to commercially sensitive information? Mr. Gabillon. So we have a very precise system, and as I said in my opening statement, we take that very seriously. So if I can describe briefly, as you know, it is an LME requirement to have an information barrier between a warehouse company and affiliated trading companies. So right at the acquisition time, we put in place a procedure that actually goes beyond the LME requirements on a couple of levels, and effectively restrict to a very small list, not the 50 people you mentioned but I believe it is 8 people right now. We receive some sanitized, aggregated information, which are really the people in my team and some of my superiors that represent the shareholders of Metro, because you will relate to that. But Metro is owned 100 percent by Goldman Sachs, and it is actually consolidated in the Goldman Sachs Group, so this means that we need--we have a need for information. So some of the people you referred to--and I believe the number is well below 50 currently, constitute of people that receive non-commercial information, primarily financial information, and they sit in our Financial Control Department. They will also sit in our Legal and Compliance Department. There are also some people that actually sit in the E-Mail Surveillance Group, and that's the information received. Then we have this policy where all this information is restricted to that very small group of people, and nothing goes to the metal sales and trading people. We have a segregated room, and we have email surveillance which is perfected by our Compliance Department. And I would say in the last 5 years, since acquisition, we never had a breach of that policy. Senator McCain. How would you know that, Mr. Gabillon? Don't Goldman employees oversee the operations of your warehousing business? How would you know whether they used that information or not? Mr. Gabillon. I am not sure what you meant by Goldman Sachs people oversees the---- Senator McCain. Goldman employees have access to sensitive information about your operations, right? Because they own it, and I think that is legitimate. What confidence do we have that they do not share it with the other aspects of Goldman's operations, which they could use to their advantage? Mr. Gabillon. We have two levels. We have the system that I described, and nothing has ever come up, so we have email surveillance which has confirmed---- Senator McCain. So nothing has ever come up is the answer to the fact that they have access to sensitive information which could give them an advantage in their other operations. So nothing has ever come up so it is OK? Mr. Gabillon. No, I would say two things. One, they do not--metal and sales trading people do not have access to any of the Metro information. Even myself as chairman of the board, the data I get from the Metro people for the perfecting of the--as a shareholder---- Senator McCain. Is there a prohibition from them sharing operation---- Mr. Gabillon. Yes, there is. Senator McCain. There is? Mr. Gabillon. There is under our policies, yes. Senator McCain. And how do we know that that is enforced? Mr. Gabillon. OK. So the second thing I was going to say, I believe 2\1/2\ years ago the LME introduced a further requirement on the information barriers which would require Metro to have a third-party certification of the information barrier policy. This audit has been performed twice by PwC, and twice Metro has passed successfully, the fact that no information, no confidential information went to metal trading people at Goldman Sachs. So that is a third-party certification which might give you additional comfort. Senator McCain. Well, I am glad you have that confidence. Unfortunately, we have seen time after time instances where that is not necessarily true, and to me it sets up a relationship which could over time lead to manipulation, and because you have had no complaint does not mean necessarily that that is the case. Mr. Chairman, I have no more questions. Senator Levin. Thank you. Senator Portman, are you ready? I can go, or you, either way. Senator Portman. Mr. Chairman, I will go ahead if that is OK. Senator Levin. Sure. Senator Portman. OPENING STATEMENT OF SENATOR PORTMAN Senator Portman. And I apologize. I was on the floor talking about one of Senator McCain's and your favorite topics--in fact, I mentioned you--which is the issue in Ukraine and what is going on with Russia. But I am happy to be here, and I appreciate your holding the hearing, which gives us an opportunity to explore the role that banks play in the commodities markets. Since Gramm-Leach-Bliley was enacted, banks have had this legal authority to engage in physical commodity activities, and I know that many end users of commodities think that the banks' involvement in this area has been beneficial. I know municipalities in my State of Ohio have told me that. The natural gas market is an example for them where they think it has been helpful. Nevertheless, I agree this is a responsible use of our oversight responsibilities to revisit that decision by Gramm- Leach-Bliley periodically and to ensure that banks are using that authority in responsible ways that do not threaten the security of our financial system. The focus of this panel is on how one particular bank, Goldman Sachs, has used its authority under Gramm-Leach-Bliley to participate in the market for a particular commodity, so this is, as I understand it, focused on one particular issue, and that is aluminum. Specifically, Goldman used its authority to purchase a company called Metro that warehouses aluminum. I understand the aluminum market is characterized by two types of warehouses: One are warehouses governed by the rules established by the London Metals Exchange, known as the LME warehouses, and then those not governed by LME rules, known as the non-LME. Metro's LME warehouses are the focus, as I understand it, of this Subcommittee's inquiry today, and I also understand that aluminum owners have three basic options for what they do with their metal. They can sell it to end users. They can store it for sale later. If they choose to store it, they can do so in LME warehouses or in non-LME warehouses. So my questions, I guess, are more about how does this all work? If you could just explain to me--and I know some of this discussion has already occurred, although we had somebody monitoring the hearing earlier who said that some of these issues have not come out yet, so let me ask some specific questions. Describe for us how the aluminum warehousing system really works. Why do aluminum owners warehouse their metal at all? How do they decide whether to use an LME warehouse or a non-LME warehouse? And let me go ahead and give you the second question that I have, which is: Since 2008 it seems that aluminum owners have increasingly chosen to warehouse their metal instead of selling all of it under the physical market. This has resulted in rising warehouse inventories, particularly at LME warehouses. Can you explain why? Why are these warehouse inventories, particularly LME inventories, increasing over the last several years? In some cases, these inventories have risen dramatically. So how do aluminum owners decide where they are going to put their metals, LME or non-LME? And why, since 2008, have we seen the increasing inventories? Mr. Wibbelman. Well, Senator, the London Metal Exchange operates as a futures market, and it is a market unto itself. It can be interacted with by the consumers if they choose to do that, but it has provided itself a market by which producers could continue to produce metal during periods when the demand was collapsing. So following the global financial crisis, for example, since that point in time, Metro has received into Detroit 3.6 million metric tons of metal, and that really acts as a strategic stockpile and a buffer stock, which really gives the consumers a chance to have some alternative sources of metal. Now, they have not entered the warehouse to take metal out directly very often, but what has happened is Metro has been shipping metal out in great quantity--600,000 tons a year for the last several years--and that metal goes to the particular owners. And those owners have a choice. They can put it back onto the LME. They can put it back--they can sell it to consumption, or they can store it off-warrant in off-warrant storage areas. And so what the LME system has done is essentially allow us to create a strategic stockpile within North America, a large one. And so that is why the argument about pricing. I mean, Metro's activities have done really, I think, nothing but amplify the competitive options that people have had, when you are talking about 3.6 million metric tons that really might never have been produced in the first place. And really it was only when the LME system rules were under some revision that smelters started to really amplify their shutdowns, for example, in your State. And so really the LME system has been quite vital for producers to be able to have a predictable customer when no customer exists in the physical consumption world. Senator Portman. Mr. Gabillon, any additions to that? Mr. Gabillon. Yes, maybe I will just add one thing, because you asked a question about whether people decide to store on the LME or not on the LME. Senator Portman. Right. Mr. Gabillon. I think to put things in context--and I think it is relevant to the earlier debate that took place on those off-warrant transactions. In the LME, you are under rules set by the LME, but you have a lot of benefits that are attached to it because you have what we call liquidity, which is, each metal is described as a warrant, and there is a trading place where you can buy and sell futures contracts that will deliver on these warrants. So if you want to be, for instance, a financier and you want to finance your metal, you will find that if you own metal under the LME, meaning stored in an LME-approved warehouse's warrant, banks will give you a lot of financing, you will have a lot of liquidity, because if your collateral needs to be foreclosed, it will be very easy for the bank to foreclose on it and then sell it into the market. And so that is under the contract of the LME. Of course, the downside of that, the LME has to have rules, so, for instance, the minimum load-out rules and when you can take it, and you might have to wait. Senator Portman. But customers are willing to have those restrictions in order to get the benefits, including more liquidity? Mr. Gabillon. Yes. And when we say ``customer,'' I think we should try to be a bit more precise. The other thing I would say of this LME warehousing system, it is not a supply storage system. It is an LME warehouse system that has been built and established to support the LME as a marketplace. So not a lot of people would use that. Producers would use that as a market of last resort when it happened in 2008 because suddenly there was a collapse of demand, and the only people that could actually buy this aluminium and finance it, to your point, was on the LME. But that is easy to deliver onto. If you buy onto the LME, for instance, it is actually the seller that decides which ones they are going to deliver. So they could be in Malaysia, they could be in Rotterdam, or they could be in Detroit. You do not know in advance. So people generally have not used the LME to provide. Then if you are storing off-warrant, very quickly, which is part of what our customers sought to do in the past, you are taking much more risk because you are on your own, if you like. You are storing metal in a warehouse somewhere. There are no rules, right? It is a bit more difficult to get financing. You need to organize the logistics. Senator Portman. And more exposure. Mr. Gabillon. And more exposure because most of the people are storing aluminum, and that is something we have not gone through yet. It is a bit more complicated, but when people own the commodity, most of the time they would have hedged it. If you have done all of that on the LME, again, your risk is very reduced because if something happened, you can just wait and deliver your LME warrant. If you are doing that in a field, though, in a warehouse which is far from an LME delivery point, you run a lot of risk between the two, and it is more complicated, and that is why banks are reluctant. So people always have to decide between those two, and right after the financial crisis, there was not a lot of confidence, funding was difficult, so that is why all this material went onto the LME. And now as the situation has improved, that is why the LME metal is trying to get out. Sorry for the long answer. Senator Portman. As the economy began to pick up--one of the questions I have, just hearing you all--what percent of the market does this particular warehouse and this company represent? The Goldman investment is in Metro, I take it. Do you have other warehouses? You are the Goldman guy, right? Mr. Gabillon. We own 100 percent of Metro. That is it. It is a bit difficult to answer the question about market share because it does vary over time. So as I said, at the beginning of the financial crisis, all this metal went onto the LME, and not a lot of metal was stored outside. If you look at it today---- Senator Portman. What percent of aluminum is in this warehouse today, the Metro warehouse? Mr. Gabillon. Today it is about a million. Mr. Wibbelman. About a million. Mr. Gabillon. A million tons, and the annual market for aluminum is about 50 million tons, and probably observers of this market would tell you you probably have something like 12 million tons being stored on the planet right now. It is difficult--we know about the LME because it is publicized, but what is outside, we do not have the data. Senator Portman. Are you saying 2 percent? Are you saying 50 and 1? Mr. Gabillon. Two percent of production; 2 percent of annual production is stored right now in Metro. Senator Portman. OK. And what percent of the aluminum that is stored is in your warehouses? Mr. Gabillon. Then it would be 1 versus 12, so 8 percent. Senator Portman. One of the things that the Subcommittee staff Report indicates is that the LME warehousing facilities at Metro affected price movements for aluminum in the United States. It sounds like it is about 8 percent of the stored aluminum. In your opinion, do LME warehousing practices have a meaningful effect on the physical price of aluminum? If not, what other factors influence that price? Mr. Wibbelman. Senator, I would say that there are a lot of actors in the marketplace, and so you have what producers choose to do, if they continue to produce metal or not. You have got financiers. We have been operating in a zero interest rate environment lately, and so the people who are owning metal are often owning it because the returns on--the safe returns on owning metal and deploying their capital into metal create a return of between 5 and 8 percent for many of these institutions and trades. That is why a lot of these institutions have wanted to own metal and were willing to buy metal in order to do it. It is because they are looking at the difference between a 0-or a 1-percent return versus a 5-or 8- percent return during this whole 5-year period at various times. Senator Portman. So how do you respond to the concern that the way you have stored the product at Metro affects pricing? What is your response to that specific concern? Mr. Gabillon. Well, Senator, I think as we discussed, there are two parts in what we call the all-in price, which is the price paid by customers. We have the LME price, which it is called the LME price because it is the price on the LME, so it is affected by LME rules, clearly. And then you have the physical premium. So as the physical premium has gone up, the LME price has actually gone down. And if you may, we have a graph which we think is pretty relevant, if we could show it to you. Senator Portman. My time is up, so it is up to the Chairman. Senator Levin. Sure, if you want to. Senator Portman. Yes, let us see the chart if you have one. Mr. Gabillon. I will start to describe it, but you are going to have it in one second. Senator Portman. And while we are getting the chart, what is the comparison to what goes on, say, in the Asian market, the Japanese market, for instance, where there is a significant amount of aluminum used, or the European market? Mr. Gabillon. Well, I think if you look globally, you will see it is not perfect in timing. But the markets tend to be reacting at the same time, so if you wanted to look at those equivalents of the physical premium in the United States and in Europe and in Asia, you would say that they have all risen at the same time. And part of the reason is also because the LME price--we have talked a lot about the United States here, but the LME price is a global price, because as I said, when you deliver aluminum on the LME, you decide where you can deliver it. So people are always calculating which metal to deliver when, and the LME price, if you think about the LME price today, it probably reflects much more the situation in Vlissingen in the Netherlands than it did. But at another point in time it would be different, so you have a constant evolution. If you look at this chart we have provided,\1\ just to put it in context, it is between the beginning of 2007 to very recently. The light blue curve is what we call the aluminum all-in price, and you could see that it was quite elevated before the financial crisis. Then it went down a lot. And then it has been moving--we have a kind of trend line. It has been moving down over the last of those years. And then we have represented as one example of what has been going on the LME, what we call the aluminum queue calculated in this, which reflects something which is well known to observers, that those queues have risen. Actually, they actually started to fall off quite a lot this year, and you can see when everything is said and done, you can see that actually there is no correlation between the increase of the queue and the all-in price that is paid by customers in the United States. --------------------------------------------------------------------------- \1\ See chart provided by Mr. Gabillon, which appears in the Appendix on page 147. --------------------------------------------------------------------------- So we know it is complicated. There are many factors. At times it varies, the dynamic varies. A lot of the people that actually observe those markets, including us, sometimes get it very wrong. But when everything is said and done, you can see that there is no correlation. So we do not believe that the LME rules impact the all-in price for customers. Senator Portman. And of all those factors--and you say it is complicated--you would say that the economy would be the No. 1 factor, in other words, the demand in the economy? Mr. Gabillon. On the all-in price, definitely. If you see again this graph, you can see that the all-in price went down pretty much a lot until the end of last year. And actually, it is only this year, with the combination of increased demand, in particular in the United States, and also a lot of smelters closures in the United States and in Europe in response to those prices, that the situation has started to shift, and now the aluminum all-in price is starting to rise at a time where the queues are very limited. Actually, if you look at it specifically in 2014, you would see that at the beginning of the year, even if you think about the physical premium itself, it started the year at 250, finished the year at--currently we are at 500. For instance, the queue in Detroit has actually been reduced a lot during the same period. So that is why I am trying to say when it is complicated, at times the correlations change. But overall we think this graph summarizes the situation. Senator Portman. If the EU economy were growing right now and the U.S. economy having picked up some steam recently, you would see this light blue line going back to here it was probably in early 2008? Mr. Gabillon. I mean, it is always difficult to speculate, but that is not impossible. I think the other thing which is starting to drive that price is as smelters have closed here, the North American sector needs to import aluminum, in particular, to the United States, and, therefore, they need to import it from abroad, and that has higher transportation costs and most of the production increase is in China these days. Senator Portman. OK. I have additional questions, Mr. Chairman, but I do not want to take your time. Senator Levin. Thank you. Just while we are on that point, I think most experts in the field will say there is a relationship, by the way, between queue length and the price that people pay for aluminum. But we are going to--and that is an important argument, but to me, an equally important argument is whether there is a relationship between queue length and what you call and everyone else calls the ``premium.'' Would you acknowledge there is a relationship--and this is something Senator Portman was getting to, I think. Is there a relationship, a direct correlation, in fact, a very high correlation between queue length and premium? Just, yes, is there a high correlation? Mr. Wibbelman. Senator, what I would say is that when the premium goes up, the value of the available metal within Metro's warehouses becomes more attractive, and so then people look for it and try to cancel warrants, and then, therefore, it becomes a longer queue. So I think it is just a question of cart before the horse. Senator Levin. No, my question is: Is there a direct, high correlation between queue length and premium? Mr. Gabillon. Senator, I would say if you look at 2014, I would say no. Senator Levin. In general, is there a high correlation, yes or no? Mr. Gabillon. First, correlation does not mean causality. Senator Levin. I did not say it meant causality. I did not ask you causality. I asked you correlation. Mr. Gabillon. If you ask me as a statistician, including the data up to today, I would say the correlation is not great, no. Senator Levin. OK. Then that is a major argument here. If you can say there is no correlation between premium and the length of the queue, then you are in a very different mathematical world than most of the mathematicians that look at this. OK? By the way, on your chart, when there was a big jump in the queue length, what happened there? Weren't there a whole lot of cancellations right there? Mr. Gabillon. So there were---- Senator Levin. Can you give me a yes or a no to that question? Mr. Gabillon. Yes, cancellation drives queue, so yes, there were a lot of cancellations. Senator Levin. That is, as far as I am concerned, the most important six words I have heard yet this morning. Cancellations drive the queue, and we all ought to remember that. OK? And then if there is a correlation between the queue and the premium, which most statisticians will say there is, then you have the important connection between the premium and the queue. And if the queue is driven by cancellations and if your contracts require cancellations--which they do if they are living up to--at that point you have your contracts requiring cancellations. In order to get discounts, you have to cancel the warrants, which in turn drives the queue, which in turn is correlated to the premium. And the premium is, by your argument, just part of the all-in price. You say it does not affect the all-in price. Most of the users will say it sure does. But that is an argument that we will take up with every panel as to whether or not the premium, if it goes up, leads to higher all-in prices. You folks differ with most users on that issue, but in terms of the premium--the premium is clearly an important part of the all-in price, and your actions are directly correlated to the premium, because you are driving the queue, as you just pointed out, and the queue has a direct correlation to the premium. Now, that is not just the price of aluminum we are talking about, folks. This is also the transactions in aluminum which Goldman are involved in, because the premium--there are transactions based on premium. And if you are right that if the premium goes up, the other part of the price will go down--that is what your argument is--you are saying then that the LME price will go down if the premium goes up. There are huge amounts of aluminum-related transactions that are based on the LME price. So if your argument is right and, again, most users disagree with your argument, and I think most experts would disagree with your argument, and we are going to hear from some of those on the next panel. But if your argument is right, two things then are affected: First, the premium, if it goes up, there are financial transactions based on that premium; second, your argument, the premium goes up, LME price goes down because there is no effect on the all-in price. At that point the effect on the LME price by the increase in the premium is part of your argument. You are saying premium is up, LME price has to go down, because the all-in price is the same. That is your argument. At that point, now driving the queue, which is obviously driven by cancellations, and the queue correlation to the premium is directly affected to the LME price, by your argument. Again, most people do not agree with your argument. Most people that use aluminum believe that when you increase the premium, which is what the queue does--forget causation, it is correlated, the length of the queue to the premium is correlated, that is what most mathematicians will say in a very high way, you are having a very significant impact on LME price and--and this is significant for Goldman, because this is what I believe it is mainly about for Goldman, are the financial transactions, because their impact on the queue by what they do with cancellations--and that is what these contracts are about. These contracts are about you must cancel. That is in the contract. I know, they do not have to live up to the contract. I understand that. They can violate the contract. But most people do not enter into contracts to violate them. And so if they live up to the contract, under the words of the contract you must immediately cancel, which means the queue goes up, cancellations drive the queue, you just said it. And the relationship, the correlation between the length of the queue at that point and the premium is a direct correlation. And at that point, under your own argument, it seems to me you lose a very significant other argument, and that is the relationship here between premium and the LME price. So I do not know if Senator Portman wants to go on. I have a lot of additional questions, but the issue, Senator, which we have just been talking about is the relationship between the premium and the queue, and there is a high correlation. This is the all-in price. They are arguing here that the all-in price is not driven by queue length, because their argument is that if the queue length goes up, the LME price--excuse me, if the premium goes up, the LME price goes down, because the all-in price stays the same. But it is the premium issue which is the issue here as well as the effect of the queue on the all-in price. But there is not much doubt in most statisticians' minds and beliefs that there is a direct, high correlation between the length of the queue and the premium. I know their argument, and I have heard it. Most of the people that we are going to hear from do not agree with the argument that the length of the queue does not have any effect on the all-in price, on the price of aluminum. But even if they are right--and most people disagree with it--where they are clearly wrong by almost any statistical analysis is the fact that there is a high correlation between the premium and the length of the queue. And once that is true, if, as they argue, the all-in price is made up of two components--one the premium, the other one the LME price--then the LME price is affected by the premium going up or down, and at that point the LME price is very significant in terms of financial transactions. So this chart is very much disagreed with, again, by most users, including the auto industry, which is using aluminum, which is a big, big problem with the way in which aluminum prices are set. Senator Portman. You are part of this, too, so I will get back to you. But they care a lot about the all-in price. Senator Levin. They do. Senator Portman. I am admitting I am no expert in the aluminum market, but why is the premium so important as compared to the price? And is this a matter of--you say correlation. Does that mean causation? And are there other things that could explain that correlation? Senator Levin. Well, when you look at their chart, that big line jump right there, is when there was a whole bunch of cancellations of warrants. The queue went up, including the ones we are talking about today. Many of them, right at that big jump right there. And this is the queue length. And so, again, the high correlation becomes critical because under their contracts, for instance, that Deutsche Bank had to immediately cancel warrants--under all their contracts. If we are talking about these six contracts, all the warrants had to be immediately canceled. That immediately caused the queue to increase. You can see it with that huge jump right there. And so the queue increases, and then the question is: Is there a correlation between the length of the queue and the premium? And there is a high correlation at that point. And the premium is a big, growing part of the all-in price, by the way. It used to be 5 percent of the all-in price. A few years ago, the premium was 5 percent of the all-in price. It is now over 20 percent of the all-in price. Senator Portman. Let me just ask you gentlemen about that. The question I just asked a second ago is does correlation mean causation? And what else would you think, assuming you agree with the correlation, would be the causation? Is it the LME rules? What is your sense of that? Mr. Gabillon. So if I may, first, to come back to our graph, that is not the theory, with just the observation of this, I think everybody can conclude from that graph. If we go back to the precise point of premium versus cancellation--and, again, I appreciate it is complicated--there is effectively--that is a factor. The queue is a factor in the premium, and there is a simple fact, which is if you receive a warrant on the LME and there is a long queue in front of you, the owner of that warrant is going to have to pay the storage fee for that period of time. So as that period goes, the LME price will go down. That is the various effect of the premium. Now, when we say queue--and this is where it gets a bit more complicated--it depends which queue you are talking about. So there is a period of time where maybe for a few days--the queue in Detroit was the longest in the LME system, and then that might have a bigger impact. But there was a period when, if you look at it today, the queue on aluminum is not the longest in Detroit. It is actually in Vlissingen. And this is a global market. This is a global contract. In the LME you do not have a contract in United States, a contract in Europe, a contract in Asia. You have one global contract, and everything is priced out. So right now the queue in Vlissingen has probably a bigger impact than any other queues in the world. So that works like this. At another period it might be different, and that is why the correlation can vary from time to time. And, yes, I mean with correlation, we can have people fighting all the time. But there are periods where it is different, and so the correlation exists at that time. And sometimes, as Mr. Wibbelman said, it is the other way around. When premium--when you look back at why cancellations started to happen, it is because the premium was starting to go up. That was a signal to the market, which is take that metal which is on-warrant, cancel it, and bring it outside. So sometimes it works both ways. That is why the correlation-causality is more complicated than that. And this market is complicated, and people disagree all the time. That is what makes markets. I will give you one anecdote how complicated it is, and Senator Levin referred to it when he showed us the big increase in cancellations in Detroit. By the way, if you had the chart of other parts of the LME system, you would see there was an even bigger cancellation a few weeks before that event, and that event happened when the LME, after doing an independent report on queues, reached the conclusion, had a consultation, and implemented the rule to double the load-out from large warehouses like ours, with a view to reduce queues. The impact on the market was that queue did not shorten, but queues became longer as a result of that. So that is an example of how even when you have the best brains that have studied this market, you look at it and try to understand what drives what and when, it is not that simple. So I appreciate that, it is a very complicated issue of correlation between premium and things, but I think it is more complicated than that. Senator Portman. By the way, the LME rules under which Metro operates, are these rules that if you were to sell the warehouse, which I understand you are thinking of doing, that the new owners would also operate under? Mr. Gabillon. That is correct. Senator Portman. And who might the new owners be if you sold the warehouse? Mr. Gabillon. We are running a sales process right now, and we have a variety of interest from companies in Europe, Russia, and China. There is a variety of them right now. Senator Portman. You think it would be a foreign owner? I do not mean to probe here, but I will. Mr. Gabillon. I think it is possible, yes. Mr. Wibbelman. Even if it is not a foreign owner, it is safe to say that the center of gravity of the business generally is going to move from the United States to Europe or to Asia, and essentially it is because the competitive environment that Metro operates in. I mean, all of the other warehouse company owners are essentially unregulated traders that operate in those areas, and so they are able to do things to acquire metal for their own warehouse companies, which will essentially create strategic stockpiles elsewhere or within those companies. Senator Portman. So if it is not owned by a bank or Goldman, it is likely to be owned by a trading company. And let me just be clear: Is that trading company going to be living under the same LME rules or not? Mr. Wibbelman. It will not have all the banking restrictions if it is not a bank, right? So it will not necessarily have that type of restriction. Many of the companies that own LME warehouse companies, the parent companies, are trading conglomerates in some cases, and they essentially, source metal for their own warehouse company, and the profit will go up vertically into the same ownership structure. I mean, Metro has been run from a profit center basis, completely separately from Goldman. In other words, we act maybe as counterparties occasionally, but not as a unified, vertical structure. Senator Portman. Thank you, Mr. Chairman. I have, unfortunately, another appointment I cannot miss, and I appreciate your testimony, gentlemen, and thank you, Mr. Chairman, for letting me come and indulging me with the time. Senator Levin. Thank you very much, Senator Portman. Let us now start with the Deutsche Bank contract under which they were required to cancel their warrants, the first one. Now, that deal was in September 2010, just a few months after Goldman acquired Metro, and it involved Deutsche Bank and 100,000 metric tons of aluminum. Here is what Deutsche Bank told us: That in September of---- Senator Baldwin. OPENING STATEMENT OF SENATOR BALDWIN Senator Baldwin. Thank you, Chairman Levin. I actually wanted to start by thanking you for your leadership of this Subcommittee. I remember our first meeting together as I became a new Senator and you talking about the importance and the power of the gavel of this particular Subcommittee, and you have wielded it so much in the interest of the American people, and I deeply, deeply appreciate your work and leadership on this Subcommittee. I also want to thank you for holding today's hearing. I am greatly concerned about the role that financial institutions are playing in physical commodities markets, and particularly aluminum, because I have heard about this issue from manufacturers all across my home State of Wisconsin, from breweries that use aluminum in their cans to Mason jar manufacturers to heavy trucks, and if you are making a product with aluminum in it, you know this issue very well. The fundamental basis for any well-functioning commodity futures market is that futures and cash converge, and I think we have seen a massive disconnect in the aluminum market, and today's Report identifies the reason. Mr. Chairman, because I know you have probed during this first panel into the relationship between the queue and the premium, my real interest is asking some questions of the second panel. I know it is going to be a little while before they come. I wanted to come here today to note my concerns. I hope to be back to ask my questions of the second panel. If that is not possible, I am going to leave my questions with you for the record, but I do not have any questions right now of this panel. I thank the Chairman for your indulgence in allowing me to thank you and state my interests in this issue. Senator Levin. We are always happy to indulge colleagues who want to thank me. Believe me, it is---- [Laughter.] Senator Levin. Thank you, Senator Baldwin, for your great involvement in so many issues involving consumers, as well as this one, and for your comments about me. I very much appreciate them. Let us get to the Deutsche Bank deal again. This was September 2010. It was just a few months after Goldman acquired Metro. It involved 100,000 metric tons of aluminum. Deutsche Bank told us that in September 2010 it entered into negotiations with Metro seeking cheaper rent for the metal that it was storing at Metro warehouses in Detroit. The LME told the Subcommittee that no LME rule prevented Metro from giving Deutsche Bank a rent discount for LME storage. So Metro could just give, if they had decided to, Deutsche Bank the discounted rent while still on-warrant in the first warehouse. Is that correct? You had the power to do that? Mr. Wibbelman. We could do that, yes. Senator Levin. And Metro has given rent discounts for LME- warranted metal in the past. Is that correct? Mr. Wibbelman. Yes. Senator Levin. Metro did not do that here. Metro instead proposed that Deutsche Bank cancel warrants on its 100,000 metric tons of aluminum ``as soon as possible.'' Cancel warrants as soon as possible, and then wait in the queue; when it got to the head of the queue, send its metal from one set of Metro warehouses to another. After a brief period, Deutsche Bank would then re-warrant the metal at the new warehouses. Again, Mr. Wibbelman, why not just let Deutsche Bank stay in the first warehouse and give it a cheaper rent? Mr. Wibbelman. Well, I mean, we are a commercial business, and we evaluate every commercial opportunity independently, according to what is in the best interests of our commercial position. In that case, I can tell you that Deutsche Bank had the optionality to move the metal out or not move the metal out. And, in fact, they did not move a great deal of the metal out. They left it in the warehouse and re-warranted it in place because it was commercially more viable for them to do that. Senator Levin. How many tens of thousands of tons did they move to a different Metro warehouse? Mr. Wibbelman. My recollection was of the 100,000 tons, they moved 70,000 metric tons, and they did not move 30,000 metric tons, and they re-warranted all the stock in--whether having left the warehouse or not having left the warehouse. Senator Levin. Exactly. It was important to you, however, that they move to another warehouse. Is that correct? Mr. Wibbelman. Well, they wanted the optionality---- Senator Levin. Was it important to you that you required them to cancel the warrants as part of this deal? Mr. Wibbelman. Senator, the issue for them---- Senator Levin. I am just asking you if it was important to you. Mr. Wibbelman. I am trying to explain that the issue is that if they do not put the metal in the queue, Metro having at that point, for example--I am just guessing--a million tons of metal in storage, then someone else could cancel metal, and that they could then jump ahead of them and make their metal less valuable. So the LME rules actually---- Senator Levin. I am just asking a simple question. Was it important to you? And is that why it was in the contract that they cancel the warrants? Mr. Wibbelman. Metro was going to make the same amount of-- -- Senator Levin. So it was not important to you? Mr. Wibbelman. So it was--we gave them an option to do it. Senator Levin. I am just asking you whether or not, if they live up to the contract, did they have to cancel warrants? That is all. It is a pretty simple question. Mr. Wibbelman. Yes, I would say that the--what we were doing was we were providing them options for once the metal left the warehouse, if that is what they chose to do, and that was the basis of the contract. Senator Levin. I take it you are not going to answer the question as to whether or not it was important to you that they cancel the warrants. Mr. Gabillon. Maybe I can try---- Senator Levin. No. Mr. Wibbelman. I am trying to answer the question, Senator. I am sorry. I think it was probably not important to me personally whether it happened---- Senator Levin. Not personally. I am talking about the company. You paid them to move 70,000 tons, did you not? You gave them a discount. Is that correct? Mr. Wibbelman. We gave them some discounts if they moved it. Senator Levin. Right. Mr. Wibbelman. But it was their choice. Senator Levin. It was not their choice whether to cancel or not? Mr. Wibbelman. Yes, it was. They owned the metal. Senator Levin. No, but wait a minute. If they lived up to the contract, they had to cancel. Once they sign a contract, is it not true that, to live up to that contract, they had to cancel the warrants? Yes or no. Mr. Wibbelman. It was not a requirements contract, it did not require them to cancel metal. If they wanted to achieve the--if they wanted to put it back on warrant from a different warehouse, then they would---- Senator Levin. Take a look at Exhibit 23,\1\ would you, please? Page 5, Section 3.1: ``. . . the Parties agree that [Deutsche Bank] will request the maximum number of Slots and place the Goods or part of the Goods off-warrant as soon as possible thereafter . . .'' That means cancel the warrants, doesn't it? Does that mean cancel the warrants? --------------------------------------------------------------------------- \1\ See Exhibit No. 23, which appears in the Appendix on page 1011. --------------------------------------------------------------------------- Mr. Wibbelman. Cancellation would be required for that, yes. Senator Levin. OK. The parties agree that they would ``as soon as possible thereafter,'' obviously ``dependent on existing demand for slots.'' But, nonetheless, as soon as possible. And then they canceled, and look what happened to the queue. See that big jump in the queue? That is what happened when they canceled the warrants. Do you think there is a correlation there between canceling warrants and the length of the queue? Mr. Wibbelman. Oh, if they cancel, there is definitely--the queue would lengthen until the metal ships out, until some of the metal shipped out. That is right. Senator Levin. OK. So I am glad we finally got to that point, that there is a correlation between canceling the queue--canceling the warrants and queue length. That is progress. Let us keep going then with Deutsche Bank. The contract was signed by Deutsche Bank, not by Metro. Did it reflect the agreement that was reached between you? Mr. Wibbelman. I mean, it was--my recollection is this was written by Deutsche Bank. It was signed and sent over by them, and that it was never executed, and---- Senator Levin. You mean never signed by you? Mr. Wibbelman. Yes. Senator Levin. You do not mean executed. Mr. Wibbelman. Well, it was never signed by me or executed by us, yes. Senator Levin. It was not executed. Didn't you live up to this contract? Mr. Wibbelman. Well, I do not--sir, I cannot tell you that these terms were---- Senator Levin. Did you live up to a contract with Deutsche Bank which was like this contract? Mr. Wibbelman. No question, generally speaking, this type of thing took place, yes. Senator Levin. Not this type. This thing took place. Mr. Wibbelman. So the reason, sir, why we do not have contracts is because how Metro's business operates is it is basically a timeline. Senator Levin. OK. Let me go back. That is not my question. Basically this contract was executed. Is that correct? This agreement was executed? Mr. Wibbelman. I can tell you that the amount of tons that were contemplated when this contract was sent across ultimately did get canceled, and some of it did ship out. Senator Levin. OK. And did you live up to the section that said that Deutsche Bank would have to pay $65 per metric ton if it sold the metal instead of moving it to another Metro warehouse and re-warranting? Was that part of the deal? Mr. Wibbelman. They did not ultimately sell any of the metal. Senator Levin. No, I know. But would they have had to--was there a penalty here? Come on, let us just get to it. The section says Deutsche Bank would have to pay--this is Section 3.8--$65 per ton if it sold the metal instead of moving it to another Metro warehouse. Am I reading it right? Was that part of the deal? Mr. Wibbelman. So generally we do have break fees to our agreements, yes. If they agree to do---- Senator Levin. I am not talking about generally. Was that part of the deal with Deutsche Bank? Mr. Wibbelman. I cannot recall specifically, Senator, I am sorry to tell you, but I would not doubt that it was not part of the deal. I just cannot tell you for certain that it was. Senator Levin. OK. You have no recollection as to whether that was part of the deal or not? Mr. Wibbelman. I do not know, Senator, if it was actually ultimately invoiced and paid out that way. Senator Levin. I am not talking about ultimately invoiced. I am talking about the deal. Mr. Wibbelman. It was perhaps a term contemplated by this agreement. Again, I do not know if it was followed through upon. Senator Levin. That would be a $6.5 million penalty for 100,000 tons of aluminum. Now, if Deutsche Bank broke the agreement to send the metal to a Metro warehouse, then Deutsche Bank would have to pay $65 a ton. That is not free metal to me, by the way. You may want to talk about as free metal, then you may want to talk about choice. But when you enter into a contract, a business contract, you have given up choice. You can break the contract. That is always a choice. You could run a red light. You have got a choice. You made a deal. I do not know why you want to suggest you did not make a deal. You are in business. You made a deal. Mr. Wibbelman. Absolutely. Yes, we did. Senator Levin. And part of that deal with that they would cancel warrants as soon as possible, and as you point out, finally, there is a direct relationship between canceling warrants and queue length. And most statisticians will tell you--and they will in the next panel--there is a direct correlation between the length of the queue and the premium. That may not always be true, by the way. Maybe that is not true every day or every year, but it is generally true. There is a correlation between queue length and premium. Why? Because the longer the queue length, the more rent that is going to be paid, and that is part of the premium, is how much rent do you have to pay on top of what the LME price is. That is what the premium is all about. It is cost of storage. So Deutsche Bank did not pay any penalty here because, after canceling warrants for all 100,000 tons, Deutsche Bank ended up keeping 30,000 warrants, as you pointed out, in the original warehouse and re-warranting it, and they sent about 70,000 tons into other Metro warehouses, and they re-warranted it. Now, let us talk about correlation. The contract, or the ``deal''--let me put it in your words--was dated September 15, 2010. Is that correct? Mr. Wibbelman. Yes. Senator Levin. Thanks. And then on September 20, 2010, Deutsche Bank canceled warrants for 100,000 metric tons pursuant to the deal. Now, would you say that you had some influence over the cancellation by entering into a deal which required them to cancel if they lived up to the deal? Mr. Wibbelman. Well, I think there were incentives that they were trying to capture, but those incentives were not all Metro. Some of those incentives were what the market was offering in terms of its ability to capture a higher interest rate on the capital it deployed, plus whenever Deutsche Bank would enter into a transaction like that, they would gain the optionality. They would have this metal, and then if the market moved in any direction or another, they would be able to take advantage of that movement. And so, for example, when the market must have moved in some way where they decided not to ship, for example, the 30,000 tons and to put it back on- warrant within its existing location, they probably did that in exchange of some market movement, I am guessing. Senator Levin. Did that contract have an effect on cancellations? Mr. Wibbelman. Certainly I would say that their choice to take advantage---- Senator Levin. No. Did the agreement---- Mr. Wibbelman. We were providing a solution---- Senator Levin. I am talking about did the agreement itself provide for cancellations. Did the deal say if they lived up to it. I know they did not have to. Mr. Wibbelman. We are part of the market. We are part of the LME's market, and I believe that this contract was--allowed Deutsche Bank to have solutions to its--to the problems that come with its---- Senator Levin. I am sure that is why Deutsche Bank signed the contract, because they were given some money to keep the warehouse there and they were penalized if they did not keep the metal in the warehouse. OK. Now let me go back to my question. Did the agreement have a provision that related to cancellations? I will read it to you again if you want. Mr. Wibbelman. Any---- Senator Levin. Not any, this one. The deal that you made with Deutsche Bank? Mr. Wibbelman. It is a condition precedent for them to cancel the warrants should they want to have the option of the incentives we were offering. That is right. Senator Levin. Did it have a provision relative to cancellations? Mr. Wibbelman. It talked about---- Senator Levin. Not talked. Come on. They do not talk. Contracts, written things, do not talk. You talk. Mr. Wibbelman. OK. Again, Senator---- Senator Levin. I am trying to get you to just acknowledge what is obvious. This contract had a provision saying that if they lived up to the contract and if they exercised the options and all the rest, that they would cancel as soon as possible. Mr. Wibbelman. That is right, as long as it is with the ``if.'' Senator Levin. Of course. You never have to live up to a contract. You can pay a penalty. Or you cannot live up to it-- you can create a reputation for yourself that you do not live up to contracts. You do not have to obey a red light. You could go through a red light. Now, did you enter into a deal with them? Mr. Wibbelman. Certainly there was a deal that took place. Senator Levin. And did that deal, if lived up to, relate to cancellations? Mr. Wibbelman. If they did cancel the metal, then, yes---- Senator Levin. No. Did it say they would cancel as soon as possible? Mr. Wibbelman. Sir, I am trying to tell you that was the contract that they wrote, that we---- Senator Levin. I do not care who wrote it. Did you agree to it? You did not sign it. Did you agree to a deal? Mr. Wibbelman. We had a deal. There is no question about that. Senator Levin. Well, you had a deal. You did not agree to the deal? Mr. Wibbelman. Yes, our deal was conditional. If they chose to---- Senator Levin. No. Did you have a deal? Mr. Wibbelman. Yes, we had a deal. Senator Levin. Did you agree to the deal? Mr. Wibbelman. Yes, we did. Senator Levin. Did the deal have a provision that, if lived up to, would require cancellations as soon as possible? Mr. Wibbelman. The deal was that if they cancel, then we will make these payments. But it was their choice to cancel or not cancel. We were not going to sue them if they did not. It was a regular---- Senator Levin. Did it say they would cancel as soon as possible if they lived up to it and exercised it? Did it have that provision? Are the words that I am looking at, am I reading them accurately? Mr. Wibbelman. Senator, I am just trying to tell you that the actual written document does not have as much weight as you are imagining and in the way the actual transaction took place. Senator Levin. Was it in your interest that they cancel? Mr. Wibbelman. I mean, they had to cancel in order to get our incentives. That is certainly true. Senator Levin. Was it also in your interest that they keep the metal in your warehouse and that they cancel? Mr. Wibbelman. Well, in our interest, Senator, would be if nobody shipped metal out of the warehouse. Senator Levin. Did they cancel? Mr. Wibbelman. They did cancel. Senator Levin. Was it in your interest that they cancel? Mr. Wibbelman. No, I do not think it was. Senator Levin. So you entered into a deal that said they would cancel as soon as possible, but that was not in your interest? Mr. Wibbelman. Well, remember that the relative bargaining power, the owner can cancel with or without our involvement, right? So we are trying to give them solutions that involve us if they move us, right? And so that is what we were doing. We were trying to provide solutions to them in the event that they canceled and moved the metal. Senator Levin. You are just telling us under oath that you did not care whether they canceled or not. Mr. Wibbelman. I cannot tell you that it was--I do not know if they have---- Senator Levin. I am asking you. You are telling us under oath you did not care if they canceled or not. Mr. Wibbelman. Well, I would have to say, Senator, that I do not recall then because I cannot tell you with certainty that I cared. I can tell you that the intent of the deal was that we are providing them with options to move--in the event that they moved it. Senator Levin. So the Deutsche Bank deal was approved by Metro's board of directors, all Goldman employees, that explicitly called for Deutsche Bank to cancel warrants for 100,000 tons of aluminum ``as soon as possible.'' That is the agreement. Then right afterwards, on September 20, Deutsche Bank canceled warrants for 100,000 tons of aluminum. So now let us look at the queue. There is the chart on the queue. This is what happened when they cancel, that dramatic spike upward in the length of the queue, jumped from about 25 days to 120 days. That is when Deutsche Bank canceled. A hundred days more now the queue is, and the queue is correlated to the premium, and the premium is an important part of the price, and unhappily, a growing part of the price for aluminum buyers. You at least I think have acknowledged now that that spike was a result of cancellation. I think you gave us that much acknowledgment. Is that correct? Mr. Wibbelman. Yes. Senator Levin. OK. And just for the record, that chart is Exhibit 1k.\1\ --------------------------------------------------------------------------- \1\ See Exhibit No. 1k, which appears in the Appendix on page 826. --------------------------------------------------------------------------- Let us look at another deal now, the fourth Red Kite deal. Metro told the LME, London Metal Exchange, that the deal was approved by a subcommittee of Metro's board on November 1. Was that an accurate statement by LME, that the fourth Red Kite deal was approved by a subcommittee of your board, which is all Goldman employees? Mr. Wibbelman. That could be true. I do not have a recollection exactly, but it would be---- Senator Levin. OK. Mr. Wibbelman. I would not say it is untrue. Senator Levin. Take a look at Exhibit 25,\2\ if you would. This is an email, I guess, from Gabriella Vagnini. Is that correct? --------------------------------------------------------------------------- \2\ See Exhibit No. 25, which appears in the Appendix on page 1026. --------------------------------------------------------------------------- Mr. Wibbelman. Yes. Senator Levin. She works for Metro? Mr. Wibbelman. Worked for Metro. Senator Levin. Worked for Metro at the time? Mr. Wibbelman. Yes. Senator Levin. And this was to someone named Barry Feldman, who was at Red Kite. Is that correct? Mr. Wibbelman. Yes. Senator Levin. And they are a hedge fund in London? Mr. Wibbelman. Yes. Senator Levin. And it says, ``Dear Barry, I hope this email finds you well. Please note, Metro's issued deal number''-- there is a deal number here. There is an agreement. Do you see the word ``agreement'' there or ``deal''? Do you see those two words? Mr. Wibbelman. Yes. Senator Levin. And then they lay out the deal between you and Red Kite. And if you look down at the bottom of that Exhibit 25, it says $36 per metric ton will be paid within 2 weeks of cancellation. That is a freight allowance, right? Mr. Wibbelman. Yes. Senator Levin. And that is like a subsidy that you are going to pay them if they do what this deal provides for. Is that correct? Mr. Wibbelman. Yes. Senator Levin. OK. And Metro is going to truck this material to an off-warrant Metro storage facility in Detroit. Is that correct? Mr. Wibbelman. Yes. Senator Levin. And then at the top of the next page, it says Metro will incur the shipping costs. Metro, you guys are going to pay the shipping cost to the other warehouse, right? Mr. Wibbelman. Yes. Senator Levin. And then it says Red Kite cancels 150,000 metric ton of aluminum in Detroit immediately. That was part of the deal? Mr. Wibbelman. Should they take up on it, yes. Senator Levin. I am saying it was part of the deal. I asked you before, part of the deal was you are going to incur shipping costs. That is if you accepted the deal, right? Mr. Wibbelman. Yes. But what I am trying to explain is that there are deals that are conditional. A condition to us paying all this stuff is that they do that. Senator Levin. Right, exactly. Red Kite cancels 150,000 metric tons of aluminum immediately. Mr. Wibbelman. Yes, because timing is important in these transactions. Senator Levin. Yes. You wanted immediate cancellation of the warrants, right? Mr. Wibbelman. Just in order for this economics to apply. Senator Levin. Right. That is what you wanted. That was part of the deal that you agreed to, right? Mr. Wibbelman. Yes. Senator Levin. And Red Kite fulfills the requirements to get into the queue. Mr. Wibbelman. Yes. Senator Levin. There is a requirement to get into the queue. Mr. Wibbelman. Yes, only if they want to cancel and only if they want to ship it out. Senator Levin. And you are going to incur shipping costs only if they ship it out, right. Mr. Wibbelman. That is right, yes. Senator Levin. So it is like every other part of this deal. Mr. Wibbelman. That is right. That is how they all work. Senator Levin. Yes, exactly. You have obligations, responsibilities, commitments. You are going to pay what you call a freight allowance, a subsidy. You will pay it if they do these things, and you are going to truck the material. If they follow through, you got to follow through. Metro will take care of the shipping costs. And they will cancel. Is it not part of all one deal here? Mr. Wibbelman. Well, it is, Senator, but they have--things happen, like just with the---- Senator Levin. I know things--I am just saying---- Mr. Wibbelman. With the Deutsche Bank transaction---- Senator Levin. Is it part of one deal or isn't it? Mr. Wibbelman. It is. But it is not to say that that is the only path by which this can be fulfilled. Senator Levin. No, they cannot---- Mr. Wibbelman. Right. Senator Levin [continuing]. Pursue the deal. Mr. Wibbelman. And just like with the Deutsche Bank---- Senator Levin. And you do not have to pursue the deal either, do you? Mr. Wibbelman. No. But with the Deutsche Bank transaction, for example, they decided not to ship the last amount. That did not happen. Senator Levin. The 30,000---- Mr. Wibbelman. Right. Senator Levin. I understand. They did not ship 30,000. They kept it in your warehouse. I got it. Did Red Kite, in fact, cancel 150,000 metric ton of aluminum immediately or promptly? Did they do that? Mr. Wibbelman. I expect they did. Senator Levin. No, not expect. You know whether they did or not, don't you? Mr. Wibbelman. Senator, there is a long timeline of this business activity. I do not have the particular recall of one deal at one moment in time, but I do not---- Senator Levin. Just another 150,000 metric tons of aluminum on trucks, hundreds of trucks going back and forth. You do not have any memory of the Red Kite at all? Mr. Wibbelman. Oh, I have a memory of it. Senator Levin. Well, let me refresh your recollection. Take a look at the deal, will you? Exhibit 25. You agreed it is all one deal? Mr. Wibbelman. What page are you on, sir? Senator Levin. Page 2. Since you do not have any recollection as to what the deal was here with Red Kite, top of page 2, ``Red Kite cancels 150,000 [metric tons] of aluminum . . . immediately.'' Does that help your recollection? Mr. Wibbelman. Sir, can you give me a page number? Senator Levin. Sure. Page 2 of Exhibit 25. Mr. Wibbelman. This page? OK. Senator Levin. Does that refresh your recollection, ``Red Kite cancels 150,000 [metric tons] of aluminum in Detroit immediately''? Mr. Wibbelman. Well, yes, I know that was part of the deal if they did it. The only question I am having is, I just do not recall that they did it. But I assume that they did. Senator Levin. OK. And then it says, ``Red Kite fulfills the requirements to get into the queue.'' Does that refresh your recollection, that there is a requirement to get into the queue? Mr. Wibbelman. Well, what that refers to, sir, is that---- Senator Levin. Not refers to. Does that refresh recollection that there was a requirement that they get in the queue? Mr. Wibbelman. That is not what this says, sir. What this is saying is that there are requirements to getting into the queue besides just canceling metal. They have to give us shipping instructions. They have to provide us with---- Senator Levin. It is all there. Mr. Wibbelman [continuing]. The rental payment, right. Senator Levin. With instructions. Yes, it says, ``Red Kite fulfills the requirements to get into the queue . . .'' Mr. Wibbelman. Right. Senator Levin [continuing]. ``. . . with shipping instructions for maximum appointments asap.'' Mr. Wibbelman. I am trying to make the distinction---- Senator Levin. What does ``asap'' mean? Mr. Wibbelman. As soon as possible. Senator Levin. Get into the queue as soon as possible. I agree, with shipping instructions for maximum appointments. Mr. Wibbelman. The distinction I was trying to make, Senator, is it was not a requirement that they fulfill to get into the queue. It was that they had to fulfill requirements that Metro generally has in order to get into the queue, right? In other words, we had a series of steps which all of these businesses have to fulfill in order to get into the queue at all. Senator Levin. Were they required to get into the queue? Mr. Wibbelman. No, they were not required to get into the queue. They were required to do it if they wanted to take advantage of the economics of this deal, though. Senator Levin. In other words, if they wanted to live up to the deal, they had to get into the queue? Yes or no. Mr. Wibbelman. OK. If they wanted to--they could have canceled the deal and not done it. Senator Levin. If they wanted to live up to the deal, they had to get into---- Mr. Wibbelman. It was not a requirements deal, sir. Senator Levin. I am just asking a very direct question. If they were going to live up to this deal, did they have to get into the queue? Mr. Wibbelman. If they wanted the benefit of our economics in this deal, then they had to do that, yes. Senator Levin. I do not know how that is any different than what I am saying. If they were going to live up to the deal and get the benefits that they saw in the deal, they had to get into the queue. Mr. Wibbelman. Yes. I am just saying it is an option for them. They had the choice. You are saying it is a requirement. Senator Levin. I am going to keep asking it until you give me an answer. Mr. Wibbelman. I have given one. Senator Levin. In order to have the economic advantages that they saw in this deal, and if they were going to live up to the deal, they had to get into the queue. Mr. Wibbelman. That is right. Senator Levin. It took an hour to get there. Mr. Wibbelman. You asked it differently. Senator Levin. No, not really, because you knew very well that people enter deals with the intent to live up to them, and they enter deals because there is an economic benefit to them. You know that. You are a business person, a very active business---- Mr. Wibbelman. In this case, it was an option deal, right? They had the option to take advantage of this or they did not. Senator Levin. To enter the deal or not, to live up to the deal or not. It is always an option. Break the deal or not. You are free in that sense. We are all free to break deals. Not if you want to stay in business for very long. Now, I think you have already answered this question. You paid them $27 million, I believe, is that correct, as part of this deal? We can go through the invoice. Mr. Wibbelman. Could have been. Senator Levin. Does that sound about right? Mr. Wibbelman. Could have been. We think of things in dollars per metric ton. We do not tend to look at totals too much. Senator Levin. Do you want to go through these with me? Because I can take the time and do it. Mr. Wibbelman. No, I will stipulate to your facts. Senator Levin. OK. Mr. Wibbelman. I am just telling you how it works. Senator Levin. That is fine. Now, would you agree with me-- I think you already have, but I better ask it to be sure--that for 100,000 tons of metal where warrants are canceled for that amount, that at a load-out rate of 3,000 tons a day, that the queue would increase from that cancellation? I think you have already agreed to that. Mr. Wibbelman. Or from any cancellation, yes. Senator Levin. Including that one? Mr. Wibbelman. Yes. Senator Levin. Now, Goldman canceled warrants, its own warrants, for over 300,000 metric tons of aluminum in 2012. Do you remember that? Mr. Wibbelman. I know Goldman has canceled warrants, yes. Senator Levin. OK. Assume that for the purpose of discussion that they canceled warrants for over 300,000 metric tons of aluminum in 2012. You do not dispute that? Mr. Wibbelman. No. Senator Levin. So with those cancellations by Goldman, did Goldman through that action lengthen the queue? Mr. Wibbelman. Yes, if they did cancel them, they would have lengthened the queue. Any cancellation lengthens the queue. Senator Levin. I believe in your written testimony today that you said that, ``The length of the queue to remove metal from Metro's Detroit warehouse is not the result of action by either Goldman Sachs or Metro.'' Now, that statement would not be true relative to the 300,000 warrants of their own that Goldman canceled. Would you agree that your written statement, at least that part of it, is not accurate? Mr. Wibbelman. What I am trying to say there is that---- Senator Levin. No, not trying to say. Would you agree that as a matter of fact that when Goldman canceled 300,000 warrants, that it did as a matter of fact increase the length of the queue? Mr. Wibbelman. Any cancellation increases---- Senator Levin. My question wasn't any cancellation. You are answering any cancellation. My question is Goldman's cancellation. Mr. Wibbelman. Yes. Senator Levin. When Goldman canceled warrants for over 300,000 metric tons of aluminum in 2012, did that cancellation directly lead to the lengthening of the queue? Mr. Wibbelman. They occupied spots in the queue and, therefore, yes, Senator, it lengthened the queue. Senator Levin. So, therefore, you would want to modify your statement, which you are free to do, and I am not your lawyer, but I would suggest you would be wise to do, that your written testimony says that, ``The length of the queue to remove metal from Metro's Detroit warehouse is not the result of action by either Goldman Sachs or Metro.'' In that case, at least, I believe you would want to acknowledge that when Goldman canceled the warrants on 300,000 metric tons that it owned, that that did have a direct effect on the queue? Mr. Wibbelman. Yes. Senator Levin. OK. Now, next question. At least one person who worked for you was concerned by this type of deal which we have been talking about. If you would take a look at Exhibit 28,\1\ this is an email sent by Mark Askew, who is co-head of sales at Metro, a long-time warehouse executive. I believe he worked for you, for several years. Is that true so far? Do you know who Mark Askew is? --------------------------------------------------------------------------- \1\ See Exhibit No. 28, which appears in the Appendix on page 1052. --------------------------------------------------------------------------- Mr. Wibbelman. Yes. Your characterization is accurate. Senator Levin. OK. In this email, Mr. Askew relays a rumor that another trading company had heard about the 100,000-ton cancellation and that ``we were blocking others.'' Do you know what Mr. Askew meant when he said ``we were blocking others'' by that cancellation? I think that is the Deutsche Bank cancellation. Mr. Wibbelman. Well, sir, at the time it was a rumor by another trader at another conference, so I did not think I paid much attention to it at the time. Senator Levin. All right. So you do not remember seeing it? Mr. Wibbelman. Well, I do not say that I did not see it. I am just saying that I do not recall having seen it at the time. Senator Levin. Do you know what he referred to when he was saying ``we were blocking others''? Mr. Wibbelman. Well, I think, as you pointed out, that he was saying that if there is a cancellation, it would occupy spaces in the queue. Senator Levin. Does that mean he would be blocking others from leaving the queue? Is that what you understand he meant? Mr. Wibbelman. No. I mean, the LME system---- Senator Levin. The answer is no, that is not what you think he would mean by that? Mr. Wibbelman. I was trying to explain that the LME system is effectively a jump ball, whoever gets there first. So it is a system where people cancel metal, and the first actor in the system is the one that is able to get in the queue. Senator Levin. In that same email, Exhibit 28, he uses the term ``Q management.'' What does that mean? Mr. Wibbelman. Well, I think that at the time we were marketing our off-warrant services to our own customers, effectively people already in the warehouse. And so what we were doing was offering them options on what they would do when the metal left the Metro system. And so part of those options were that it could be re-warranted. And, remember, at this same time, we had a lot of metal that was going to our other off- warrant competitors. It was leaving Metro and going--again, another thousand feet or whatever to Metro competitors who were LME warehouses. And so we were just competing for that same business. Senator Levin. The Deutsche Bank deal was, as we have said, the first of six of these merry-go-round deals, and the next four were with Red Kite. As we indicated, that is the hedge fund in London. It took place in 2012. They involved a total of over 400,000 metric tons. And in each deal, they agreed to cancel warrants, wait in the queue, get to the head of the queue, transfer the metal from one set of Metro warehouses to another, and then re-warrant the deal. Each time, if Red Kite did anything other than send the aluminum to another Metro warehouse, it had to pay a substantial penalty. And in January, February, and March 2012, Metro entered into three separate merry-go-round deals with Red Kite. In these deals, Red Kite was paid to cancel its warrants, join the queue, pay again to re-warrant the aluminum in other Metro warehouses. Mr. Wibbelman, before entering these deals, did you consult with Mr. Gabillon and the Metro board of directors or a board subcommittee? Mr. Wibbelman. Yes. Senator Levin. Would you say then it is fair to say that each of these deals was a joint Goldman-Metro decision? Mr. Wibbelman. Some of the deals were specifically authorized by the subcommittee, and others of the deals were sort of vetted and understood. But generally we were aligned on the transactions. Senator Levin. So is it fair to say these basically followed a joint Goldman-Metro decision? Mr. Wibbelman. Yes. Senator Levin. OK. Now, the fourth and the last Metro deal with Red Kite was on November 5. It called for Red Kite to start canceling warrants ``immediately.'' Red Kite started canceling warrants 2 days later, on November 7, and the deal ultimately included over 180,000 metric tons of aluminum. The invoice, Exhibit 22a,\1\ showed Metro owed Red Kite $26 million in payments due under this deal. --------------------------------------------------------------------------- \1\ See Exhibit No. 22a, which appears in the Appendix on page 1002. --------------------------------------------------------------------------- Now, Exhibit 25,\2\ if you will take a look at it, Mr. Wibbelman, reflects the terms of the last Red Kite deal. It is an email from Metro to Red Kite on November 5. And if you will go to the top of page 2, where it says, ``Red Kite will cancel 150,000 [metric tons] of aluminum . . . immediately.'' And we have gone through that word ``immediately,'' and Red Kite will cancel, and I think it is pretty obvious you cared if they were going to comply, and you finally agreed that if they were going to comply with the deal, it was important that they comply with the whole deal, and that was that they cancel 150,000 metric tons of aluminum immediately. And then they will fulfill the requirements as part of this deal ``to get into the queue with shipping instructions for maximum appointments asap''--as soon as possible. --------------------------------------------------------------------------- \2\ See Exhibit No. 25, which appears in the Appendix on page 1026. --------------------------------------------------------------------------- Now, if you go back to page 1 of that deal, Metro agreed to pay Red Kite $36 per metric ton within 2 weeks of cancellation, cancellation of the warrants. Metro agreed to pay and ultimately did pay, and you have, I think, agreed to that so far. Right? Mr. Wibbelman. Yes. Senator Levin. And Red Kite got in line to leave. Is that correct? Mr. Wibbelman. Yes, to my recollection. Senator Levin. And then when Red Kite canceled, you now, I think, have agreed finally that that will lengthen the queue. Mr. Wibbelman. Yes. Senator Levin. Mr. Wibbelman, at the end of the fourth Red Kite deal in December 2012, the queue to leave the Metro warehouses in Detroit was about 500 days long. Mr. Wibbelman. Yes. Senator Levin. Did Red Kite's cancellation of warrants on 400,000 metric tons of aluminum over the course of the year contribute to the length of the queue? I know there were lots of cancellations, but did their cancellations contribute to the length of the queue? Mr. Wibbelman. Any cancellation---- Senator Levin. Including those. Mr. Wibbelman. Including those, yes. Senator Levin. Mr. Wibbelman, the LME told us that queues were never terribly long nor persistent prior to Metro's acquisition by Goldman. Was that accurate, what the LME told us? Mr. Wibbelman. Yes. Senator Levin. And then shortly after Goldman acquired Metro, the queue grew from under a month to nearly 2 years. Metro has the power, I believe, to load out more metal and bring down the queue. Is that correct? You could do that if you wanted to? The 3,000 tons is a minimum, not a maximum, right? Mr. Wibbelman. Right. We did adjust from 1,500 to 3,000, so we presumably could adjust further upward if the LME changed the rules, yes. Senator Levin. Well, you could do that without LME changing the rules. Mr. Wibbelman. Yes. But our business model is based on the LME rules and our conforming to them. Senator Levin. Yes, but you could do that. You are not violating the rules by loading out more than 3,000 tons, are you? Mr. Wibbelman. No, but Ford could sell cars for $2,000 also. They do not do it. Senator Levin. I am not suggesting that--and I do not know what Ford's pricing is. What you said may be true, it may be not true. I am sure they subsidize some cars and make profit on other cars. But that is a different issue. The point here is you could load out more than 3,000 tons if you want to, right? Mr. Wibbelman. If we adjusted the business, yes, we could. Senator Levin. And the queue then is significantly in your control, the length of the queue. Mr. Wibbelman. We have---- Senator Levin. You say you have no control over the queue. You enter contracts which require people to increase the queue. If they live up to the contract---- Mr. Wibbelman. But there are many other participants in the contract that--and in the queue with whom we did not have any such contracts. Senator Levin. I understand. I am just talking about the contracts that you did have, probably hundreds of thousands of tons. Mr. Wibbelman. But there are also many other pricing components in the whole marketplace, other warehouses around that have as much as 4.5 million tons of metal that is available without going through the queue. Senator Levin. Exactly right. Mr. Wibbelman. So we are not the only actor. Senator Levin. Oh, I know. That is exactly the point, without going through a queue, a queue that is very important to Goldman. Instead we have these incredible merry-go-round deals that I do not know--they never existed before Goldman. Do you know of any other warehouse that goes through those kind of deals, they move from one warehouse to another, a few hundred feet sometimes, pay people to cancel warrants, and then they penalize them if they do not do that, if they live up to the deal, and then they pay them again to re-warrant at another warehouse? Do you know of any other company that does that? Mr. Wibbelman. Well, Senator, I do not have visibility into what all of my competitors do, but all of the warehouses in the LME system are quite close together, generally. Detroit is really an exception where we have 1,600 square miles of eligible space in the tri-county area. So a lot of these areas are in tiny little ports. Senator Levin. Mr. Gabillon, in addition to sitting on the Metro board, you have a full-time job, I believe, as an executive at Goldman Sachs. Is that correct? Mr. Gabillon. That is correct. Senator Levin. And right now you are head of the Global Commodities Principal Investments Group at Goldman? Mr. Gabillon. That is correct. Senator Levin. And in 2010 you led the analysis to acquire Metro. Is that correct? Mr. Gabillon. That is correct. Senator Levin. And at the time Goldman acquired Metro, according to Goldman's records, Goldman owned no physical aluminum and in the months leading up to it had less than 50,000 metric tons of aluminum. And after acquiring Metro, Goldman's physical aluminum trading spiked to over 1.5 million metric tons in December 2012. Is that true, sound true? Mr. Gabillon. I do not know the specific numbers, but that sounds the right direction. Senator Levin. Sound about right? Mr. Gabillon. I do not know the exact numbers, but the direction of travel, yes. Senator Levin. Well, would you say it sounds about right? I know the directions are right, but the direction would be right if they moved from 50,000 to 100,000. I am saying here the direction, according to Metro, Goldman's physical aluminum trading spiked to over 1.5 million metric tons from zero or at the most 50,000 metric tons before it bought Metro, and my question is: Does that sound about right? Mr. Gabillon. That sounds about right, except I do not know the numbers, but I believe the metal trading group made some hires in 2010 and 2011 that probably resulted into this increased business activity, yes. Senator Levin. OK. Now, you told the Subcommittee that about the time that Metro was acquired by Goldman that Goldman hired two aluminum traders that you had referred to them, and these were traders that you knew from your years in the business with whom--I am sorry. This is to Mr. Wibbelman. Mr. Wibbelman. That was my testimony. Senator Levin. I misspoke. This is to Mr. Wibbelman. That at the time Metro was acquired by Goldman--and let me repeat it because I was addressing the wrong witness. I apologize. Mr. Wibbelman, you told the Subcommittee that about the time Metro was acquired by Goldman that Goldman hired two aluminum traders that you had referred to them, traders that you knew from your years in this business and with whom you had good relationships. Is that true? Mr. Wibbelman. Yes, Senator. Senator Levin. OK. I want to talk about these information barriers that is your policy. LME-approved warehouses acquire the following kind of information: Warehouse metal stocks, information about the size of those stocks, the current and future metal shipments, LME warrant cancellations, warehouse queue length information that is not available generally to market participants. Now, the LME has recognized that traders privy to this kind of warehouse information before it becomes available to the broader market could use that non-public information to benefit their trading strategies, which would gain an unfair advantage over the rest of the market and over their counterparties. Now, as I said before, this type of information about warehouse queues is so sensitive and valuable that the LME will not publish it. And in a 2013 report, the LME said it does not publish detailed information on warehouse stock in queues because ``the danger is that those merchants and trading houses with the most well-staffed analytical capabilities will take advantage of the availability of data to derive a trading advantage.'' To prevent confidential information from the warehouse from improperly flowing to traders, the LME requires warehouses to create information barriers. Metro has a policy implementing that requirement, and I happen to agree with what I believe Senator McCain was driving at before about the potential value of that information and how that value is very readily available to somebody who could profit from it. Now, we have 50 Goldman personnel who have been approved to receive confidential information about the warehouse. If you will look at Exhibit 40,\1\ pages 2 and 3, those are two lists of Goldman personnel who are allowed to receive confidential Metro information. Exhibit 40. And that list includes, if you look at it, people who trade commodities and who supervise commodity traders. Is that right? That is for you, Mr. Gabillon. --------------------------------------------------------------------------- \1\ See Exhibit No. 40, which appears in the Appendix on page 1236. --------------------------------------------------------------------------- Mr. Gabillon. This list includes some people that are involved in trading, but not in metal trading. Senator Levin. OK. But they are involved in trading? Mr. Gabillon. I believe there is one board member who is involved in natural gas trading. Senator Levin. And that is a commodity? Mr. Gabillon. Yes. Senator Levin. He is a commodity trader? Mr. Gabillon. But he is not a metal trader. Senator Levin. Right. Not metal, but he is a commodity trader. Now, I do not believe that we should have to rely on Goldman employees not sharing this information with other Goldman employees, information which is important to the economic interest of the company that they work for. I just do not think we can rely on a private policy to make sure that this does not happen. The stakes here are too great, and it ought to be--as far as I am concerned, it should be illegal to share this kind of information. It is also unethical, that is clear, but when you have a huge economic interest that is on the other side of ethical interests, too often the ethical interests give way. Now, Mr. Wibbelman, in June 2013, Mr. Whelan--that is Mark Whelan, I believe--quit. And take a look at Exhibit 30,\1\ which is Mr. Whelan's resignation email. And here is what he writes. He says: ``I have some questions and concerns regarding the Chinese Wall Policy that is in place which regulates the interaction between Metro International, its customers, and J Aron.'' Now, J. Aron--and I want to finish the email, and then I will tell you who J. Aron is. But he says: ``I have some questions and concerns regarding the . . . Policy that is in place which regulates the interaction between Metro . . ., its customers, and J Aron.'' And then he goes on to say, ``This morning's confrontation was extremely questionable.'' --------------------------------------------------------------------------- \1\ See Exhibit No. 30, which appears in the Appendix on page 1060. --------------------------------------------------------------------------- Now, J. Aron is Goldman's leading commodities subsidiary that executes its trades. Is that correct, Mr. Wibbelman or Mr. Gabillon? Mr. Wibbelman. Yes. Mr. Gabillon. Yes. Senator Levin. OK. And what was the confrontation all about, Mr. Wibbelman? Mr. Wibbelman. So the trader in the middle of our night approached Mr. Gabillon with a complaint effectively about Metro in a transaction. But it was referred immediately to Goldman Compliance, who investigated the issue, and the issue was about Goldman's, J. Aron's trading information. In other words, the Chinese Wall Policy is meant to protect information from Metro from flowing up to Goldman. This was about J. Aron's own trading information, and so it was not really confidential information; it was really just flowing in the other direction than the policy is intended to block. In other words, Goldman could tell people about their own trading positions if they chose to. Senator Levin. And there is nothing in the Chinese Wall Policy, even if it is implemented properly, that stops Goldman from sending direction and information to you? Mr. Wibbelman. Well, this is about their own business in which we were usually conversing. Senator Levin. They own you, right? Mr. Wibbelman. Yes. But we are owned by the private equity side of Goldman, not the trading arm. Senator Levin. I understand. Goldman owns you. Mr. Gabillon. But I think---- Senator Levin. No, wait. Goldman owns you. Is that right? Mr. Wibbelman. We are owned by a subsidiary of Goldman, yes. Senator Levin. And there is nothing in even the Chinese Wall Policy, if it were implemented, if you could rely on it, which affects information flowing from Goldman to you? Mr. Wibbelman. That is not what the Chinese Wall Policy is intended to do. That is right. Senator Levin. And is there anything that prevents information coming from Goldman to you? Mr. Wibbelman. They have their own confidentiality policies about their own information, but that is not what this is about. Senator Levin. But the Chinese Wall Policy does not stop that flow? Mr. Wibbelman. It does not. Senator Levin. OK. Mr. Wibbelman. It is not intended to. Senator Levin. Is there anything that stops Goldman from giving you direction, saying we want you to do X, Y, and Z? Is there anything that stops them from doing that? Mr. Wibbelman. So the way that it was set up, Senator, is that Metro operates in a silo, and J. Aron operates in a silo, and occasionally we have--we do sort of commercial business like with any other customer. And so we really do not listen much to J. Aron about anything other than their own business. Senator Levin. But there is nothing that stops that information from flowing? Mr. Wibbelman. There is no---- Senator Levin. There is no policy that stops the information from flowing to you? Mr. Wibbelman. I do not know about J. Aron's internal policies. Senator Levin. You do not know about a policy? Mr. Wibbelman. Not about their policy---- Senator Levin. Or Goldman's policy. Mr. Wibbelman. So I know about what Metro can---- Senator Levin. No. I know what Metro can convey in that direction. I am talking about the other direction. Mr. Wibbelman. Correct. I do not have any visibility into that. Senator Levin. All right. So the Chinese Wall Policy, even if it is not a tissue paper, is a one-way information barrier. Mr. Wibbelman. It is, but we are the ones with what is supposed to be the confidential information, right? So they have information which may or may not be confidential, and that is for them to determine. Senator Levin. Did Goldman traders routinely talk to Metro employees about their metal and about seeking discounted or free rent? Is that a routine matter? Mr. Wibbelman. It is at least an occasional matter, and at various times it has been--we talk to them about their own metal or about just their ability to acquire metal, yes. Senator Levin. And about discounted or free rent? Have you talked to Goldman traders about that? Mr. Wibbelman. Have, yes. Senator Levin. Goldman approved the freight incentives? The freight incentives, the subsidies, that was approved, as you said already, by Goldman? Mr. Wibbelman. Yes, we had transactions in which there were freight incentives involved, yes. Senator Levin. All right. And it approved each and every one of the six merry-go-round deals and decided not to take steps to shorten the queue, when it could have? Goldman can shorten that queue anytime it wants. You have already acknowledged that. They can load out more. They can tell you to load out more. And you have the power to load out more and to reduce the queue. At the same time all of this is happening, Goldman is trading in aluminum-related financial instruments whose prices are impacted by those decisions. If that is not a recipe for manipulation, then I have not seen recipes for manipulation. It is just vivid. I mean, they are engaged in financial transactions involving aluminum. They can change the queue and the length of the queue which affects the premium, and that premium, even by Goldman's argument, is an important part, it is a growing important part, now 20 percent, of the all-in price for aluminum. I mean, that is just a recipe, again, for the kind of manipulation which--we have to prevent that, I believe. Now, company policy I know says on a slightly different issue, information about your transactions, Mr. Wibbelman, are not supposed to go to Goldman. I understand that. But a whole bunch of their employees get that information who are engaged in trading. Maybe not trading metals. Engaged in trading. And just to rely on a company policy in terms of information sharing, which is very beneficial and useful to a trader, is not good enough for me. Do you think we ought to make it illegal for a company to be using that kind of non-public information? Mr. Wibbelman. Well, Senator, to answer that, I would say that one thing you need to do if you do that is to take a look at the whole complex of actors in the international system and not just banks, because the banks act somewhat commercially, and economically they do. But there are other actors that act with sovereign interests and as unregulated traders. And they also own warehousing companies, and they also have large inventories, and they have trading positions, and they act vertically. So we act separately with intentionally separate economic interests, and they act vertically with a lot of cooperation. Senator Levin. Well, we cannot protect our economy from other--we can, but not in this particular discussion. There are other ways of protecting our economy from wrongdoing from other countries. But we have to protect our economy from banks---- Mr. Wibbelman. Well, Senator, what I would say is that---- Senator Levin. Excuse me. We have to protect our economy from banks that engage in huge involvement in commodities which can open up some real possibilities about their own health, and that means the economy's health. But I am particularly interested in this potential here and this reality of manipulation, because there is just no doubt that queues were affected, influenced, and manipulated in contracts which this warehouse company entered into, a warehouse company owned by Goldman. There is no doubt that these six deals that we talked about, which you obviously welcomed as a warehouse company and Goldman approved, had a direct influence, as we can see from the chart, on the length of the queue, given the correlation between the length of that queue and the premium price of aluminum and the importance of that premium price, by everybody's measure--even Goldman acknowledges it affects the all-in--not the total all-in price, but it affects the size of the LME price, because Goldman argues that if the premium price goes up, the LME price then goes down. That is Goldman's argument. So, therefore, the length of the queue even by Goldman's argument has an impact on how the pieces of that price, that all-in price, come together. And Goldman is trading on those pieces. Mr. Wibbelman. Senator, I would say one thing, and that is that---- Senator Levin. You do not have to--you can respond. I will give you a minute. But I am talking about Goldman here. Mr. Gabillon. Senator, can I---- Senator Levin. We will give you a chance to respond. Mr. Gabillon. Thank you. Mr. Wibbelman. I would just like to say one thing, which is that there are, as I mentioned, many international actors in the system and you have to give us credit--Metro credit for having brought in 4.6 million metric tons of aluminum into the system, and that created, again, a buffer stock for these consumers without which they would have only a single source of supply, the actual producers of metal. Someday those producers might only be in Russia, right? And so we brought a strategic stockpile into the United States. I mean, China has an actual entity which actually collects strategic stockpile---- Senator Levin. The issue is not whether you bring a strategic stockpile into the United States. The question is the rules of the game relative to that strategic stockpile, and we cannot allow that stockpile to be used to manipulate a premium on aluminum. We cannot allow that because that premium, in the eyes of most, affects the price of aluminum, and even in the eyes of Goldman affects the LME price, because Goldman argues the LME price goes down as the premium goes up, and that means that the overall price, the all-in price is not affected by these kinds of maneuvers. OK. If Goldman is right, then they still have this huge potential to use the queue length in order to affect the premium, and they deal in these premiums, and they deal in the LME price in their financial transaction side. That is what we cannot allow. I do not have any problem in your business gaining more aluminum. It is the way in which Goldman is using this product, this particular facility. Mr. Gabillon. So, Senator, if I may, sir? Senator Levin. Yes. Mr. Gabillon. So we are absolutely aware of the risk that you mentioned, and this is why we have all those information barriers. And as I mentioned earlier, we do not rely only on the Goldman Sachs surveillance that takes place. PwC has audited the information barriers twice in the last--it is now a requirement under the LME rule. It has happened twice already. It is going to happen every year going forward. And all those audits have been successfully passed. Our information barrier policy goes above and beyond the LME. I am responsible on the board. I see all the information. There is no confidential information that goes to those 50 people. Senator Levin. You do not mean that there is no confidential information that goes to those 50 people. Those 50 people get confidential information. Mr. Gabillon. No. I think most of the 50 people here are in our financial control and compliance and legal to actually help the risk--to control the risk on this company. Senator Levin. Are they all allowed to get that confidential---- Mr. Gabillon. No, they are not. Compliance conveyed--even the information I receive, Senator, is not actionable as a trader. It is delayed, it is sanitized, it is aggregated. It is not per location. It is all controlled. We have a system in place on that. Senator Levin. Different people get that information in different real time. Is that correct? Mr. Gabillon. Not real time---- Senator Levin. No. Some of those 50 people get it in real time. Mr. Gabillon. No, nobody ever gets---- Senator Levin. Are they allowed to get it in real time? Mr. Gabillon. No, they are not. Senator Levin. OK. We are going to take that up later. Mr. Gabillon. We are up here to discuss it. The other point I would make---- Senator Levin. OK. I want to go back to one thing that Mr. Wibbelman said, by the way, when you say you are a reasonable source of supply, with a 600-day wait---- Mr. Wibbelman. But people are choosing to cancel warrants during that time because they perceive the relative value, right? Here is the issue. The other warehouses in the world, the metal is not available without the consent of the seller, right? Senator Levin. Of course. Mr. Wibbelman. The difference was Metro's warehouses really from day one, the metal has been freely available, and that is what has been giving people the chance to make a value decision on whether it has been worthwhile or not to cancel. Senator Levin. Is it freely available with a 600-day wait? Is that aluminum available? Mr. Wibbelman. Those are the warrants at that time that were in circulation. If you would trade on the LME---- Senator Levin. I am just asking, is that aluminum freely available? That is all I am asking. Mr. Wibbelman. It is available to own, and they make a decision---- Senator Levin. Not own. To get. Mr. Wibbelman. It was available to get, but---- Senator Levin. Not was. Is. Mr. Wibbelman. Well, the warrants were available to get. Senator Levin. Not warrants. Is the aluminum available? Mr. Wibbelman. But they generally know that, and then they do not---- Senator Levin. I am asking, is that aluminum, which is subject to a 600-day wait, available? That is all I am asking. And the answer is no, that aluminum is not. Mr. Wibbelman. It is relatively more available than the metal in all of the other warehouses where the seller does not want to sell. Senator Levin. Well, it is more available--if you cannot buy it anywhere else, then it is more available if there is no other aluminum you can buy. I am just asking you---- Mr. Wibbelman. What I am saying is there are a lot of actors in the system, and they have big stockpiles of metal, and they are not selling. Mr. Gabillon. I think Mr. Wibbelman refers to all the other warehouses in the LME system that are not flowing at all, not even with a queue with no flows. Senator Levin. Fine. If you cannot buy aluminum anywhere else, that is fine. I am just asking whether aluminum with a 600-day wait is freely available. That is all I am asking. And the answer is no, that aluminum is not. It is a 2-year wait. That is the answer. It is the obvious answer. That is OK. I am not going to get even obvious answers. I understand that. Here is what we have, and I am going to wind up here. Goldman acquires a business, and everything changes, and that is Metro's business we are talking about. Metro had not ever paid enormous freight incentives before. They had paid some, but they went up in a huge way, the amount of freight incentives, subsidies. Metro had never entered a merry-go-round deal before. These were unique. It had never had enormous queues before. A couple of Metro salespeople who had been in the company for a decade quit after raising concerns about these practices. Now, here is where Goldman sits in all this. Goldman is in the catbird seat. It controlled or had a say over every variable about Metro and through Metro. It impacted aluminum prices, current and future. It impacted the premium. It impacted the LME price by Goldman's argument. Other people will argue--and we will hear from them--that it directly also had an impact on the all-in price, but even by Goldman's argument, again, it impacted the LME price. And I think it is clear that I am not a statistician--every statistician says there is a huge correlation between the length of that queue and the premium. Goldman employees had a say over how much incentives Metro would pay to attract aluminum, and they approved previously unprecedented levels of incentives. They had a say and agreed to the merry-go-round deals. They approved them to keep aluminum in the warehouses, block the exits, and that resulted in longer queues and higher premiums. Goldman itself--and this one is now undisputed, by the way, undisputed, even with these witnesses. Goldman canceled warrants and lengthened the queue. Goldman could have shortened the queue that it helped create by directing Metro to load out more metal, but it did not. All the while Goldman is engaging in its own trading of financial instruments related to aluminum, including trading in futures contracts. We thank you. We thank you for your cooperation with the Subcommittee, by the way. Both of your companies have been cooperative with the Subcommittee in terms of providing information to us, and we appreciate that, and we will now move to our second panel. Mr. Gabillon. Thank you. Senator Levin. We will now call our second panel of witnesses for today's hearing: Jorge Vazquez, Founder and Managing Director, Harbor Aluminum Intelligence Unit LLC, Austin, Texas; and Nick Madden, Senior Vice President and Chief Supply Chain Officer, Novelis Inc., Atlanta, Georgia. We very much appreciate both of you being with us today. We look forward to your testimony. According to our rules, everyone who testifies in front of us is sworn in, so we would ask you both to please stand and raise your right hand. Do you swear that the testimony you will provide to this Subcommittee will be the truth, the whole truth, and nothing but the truth, so help you, God? Mr. Vazquez. I do. Mr. Madden. I do. Senator Levin. Your written testimony will be made part of the record in its entirety. The red light will come on in front of you about 5 minutes from now. We would ask that you try to limit your oral testimony to 5 minutes, if you could, and before that red light comes on, there would be a light change from green to yellow about a minute before the end of the 5 minutes. So, Mr. Vazquez, why don't you go first, and then Mr. Madden. TESTIMONY OF JORGE VAZQUEZ,\1\ FOUNDER AND MANAGING DIRECTOR, HARBOR ALUMINUM INTELLIGENCE LLC, AUSTIN, TEXAS Mr. Vazquez. Thank you. Good afternoon, Chairman Levin, Senator McCain, and other Members of the Subcommittee. Thank you for your invitation to provide my views on areas related to aluminum warehousing and market premiums. --------------------------------------------------------------------------- \1\ The prepared statement of Mr. Vazquez appears in the Appendix on page 148. --------------------------------------------------------------------------- I would like to summarize my opinions in the following four points: Since 2010, the North American aluminum consumer has lacked an efficient market of last resort to go to. Harbor estimates that North America will end 2014 with an aluminum production deficit of 2.4 million tons of aluminum. Although 1 million tons of metal is stored in LME Detroit, an aluminum consumer who would like to source metal from these warehouses faces a load-out waiting time of 665 days. As a reference, prior to 2010, waiting times averaged less than 2 weeks. This long waiting time of 665 days and the capital requirements to source the metal out from these warehouses makes it prohibited for the consumer to effectively use the LME as a backup. This is taking place as North America is experiencing a growing aluminum deficit. A critical mass of metal was allowed to be formed in Detroit Metro. This has created unprecedented effects. By January 2009, as a result of the aluminum market surplus generated by the economic crisis, LME Detroit had accumulated 342,000 tons of aluminum in its warehouses. Baltimore had also the same volume, but diluted among survival warehousing companies. This concentration of metal in one warehousing company gave Metro the ability to offer more warehouse incentives than any other company, the ability to outbid the aluminum consumer, and the start of a self-feeding cycle that allowed the company to permanently increase the metal stored in its warehouses in spite of a growing market deficit. One month after Detroit's critical mass and dominance position was established, Goldman Sachs acquired Metro. When Goldman acquired Metro, LME Detroit had an equivalent of less than 44 days of a load-out queue. Five months later, LME Detroit started to experience ongoing massive and unprecedented cancellations which lengthened the queue to an unprecedented waiting time of 702 days by May of this year. In my view, the lengthening of Detroit's queue to unprecedented waiting times has impacted market premiums, the all-in price of aluminum, and the aluminum consumer. While the logistical cost to source metal from Russia and the Middle East, North America's main aluminum suppliers, has remained stable since 2009, the cost of sourcing metal from LME Detroit has increased more than tenfold. As the cost of sourcing metal from LME Detroit increased, so did the reference point for consumers, traders, and producers to negotiate with. As a result, the Midwest Premium is today ten times higher than what it was in 2009. Harbor estimates that the lengthening queue in Detroit has cost the North American aluminum manufacturer at least $3.5 billion since 2011. There are warehouse practices that may pose a conflict of interest. Paying warehouse incentives to attract metal is a standard and historical practice. What is certainly not a common practice, however, is when LME warehouse operators offer and pay an incentive to warehouse customers to cancel metal and wait in the queue. That practice poses serious conflicts of interest because incentivizing the lengthening of load-out queues can materially impact market premiums. Thank you. Senator Levin. Thank you. And, by the way, if you would just spend a minute telling us what Harbor Aluminum does, what is your role and goal? Mr. Vazquez. I am the Founder and Managing Director of Harbor Aluminum, which is an independent, privately owned consulting firm that specializes in analyzing the aluminum industry and its various markets, and in providing market intelligence to our customers. We serve over 300 clients along the entire supply chain in every region of the world. Senator Levin. Thank you. Mr. Madden, we will hear from you next.. TESTIMONY OF NICK MADDEN,\1\ SENIOR VICE PRESIDENT AND CHIEF SUPPLY CHAIN OFFICER, NOVELIS INC., ATLANTA, GEORGIA Mr. Madden. Chairman Levin, and Ranking Member McCain, I very much appreciate this opportunity to speak to you today and to answer your questions. --------------------------------------------------------------------------- \1\ The prepared statement of Mr. Maddin appears in the Appendix on page 164. --------------------------------------------------------------------------- My name is Nick Madden, and I am the Senior Vice President and Chief Supply Chain Officer of Novelis. Our company is headquartered in Atlanta. We are the world's leader in aluminum rolling and recycling, and we are also the largest buyer of aluminum in the world, with a buy of about 3 million tons. I am responsible for that, and I have been in the industry for 36 years. For the last 3\1/2\ years, Novelis has been very public in our advocacy to restore normal functioning to the market, specifically around the London Metal Exchange warehouse practices. The warehouse issue is having a profoundly negative impact on our customers' businesses, and our customers include some of the most famous brands in the world, with beverage companies like Coca-Cola and Anheuser-Busch, automakers like Ford, General Motors, Chrysler, and BMW, and consumer electronics manufacturers like Samsung and LG. As an aluminum roller, we seek to keep ourselves neutral to movements in the London Metal Exchange price. But last year, our Asian operations took a $40 million hit as a result of this issue. The consequences are equally serious for consumers in the United States. Supply and demand in the aluminum market has been completely upended in recent years, and since 2010, when the banks and trading companies bought into the warehouses, aluminum premiums have tripled. Now premiums are at the highest levels ever in history, and last year this was coincident with inventories being at the highest level ever in history. It is an unprecedented situation in the history of the global aluminum market. So for companies like us--we are an aluminum converter--we have three key issues: First, inflated premiums. We estimate that consumers around the world--and this is a conservative estimate--are paying at least $6 billion a year more than they should be. The second is supply chain risk. If I buy metal from Detroit today, I have to wait until September 2016 to pick it up. And then, finally, price exposure. With the premium now at 20 percent not 5 percent of the all-in price, we can no longer manage price risk effectively. But the most serious issue is the inflated cost. Whether it is for a truck or a smartphone or a beverage can, the American consumer ultimately will pay the price, and we liken this to a hidden tax on the price of today's aluminum products. All this is happening at a time when the aluminum industry is in actually a very healthy situation. We see strong growth around the world, but the most exciting growth is in the automotive sector, specifically in North America. And my company has invested $400 million to meet that growth and added 375 highly skilled jobs in our plant in Oswego, New York. So you can imagine our frustration when we see threats to the supply chain and to the competitiveness of aluminum as a result of what appears to us to be an engineered squeeze in our market. While the LME has finally begun to act, progress is slow, and the situation on the ground gets worse every day. So what is the fix? Because I know everything cannot be fixed today, but if I had a magic wand and could make things improve, there are three things that we would like to see happen which we think would benefit our company, our industry, and the American consumer. The first of those is banks and trading companies should not be allowed to own warehouses. Second, we need to clarify the scope of the CFTC to ensure that there is no vagueness over its coverage of the warehousing attachment to the LME market. And, third, warehouses should not be allowed to charge rent once a warrant has been canceled, and we believe if you implement that, the incentive for this whole problem would disappear overnight. So, again, as the world's largest buyer of aluminum and on behalf of Novelis, I thank you for this opportunity and would be very happy to answer questions. Senator Levin. Well, thank you both for coming and for your testimony. It is very powerful testimony. Mr. Madden, I think you perhaps have already answered this, but I am going to ask a question in a way that perhaps you could expand a bit on what your testimony is. I think as a result of our investigation and Report probably you have learned for the first time about the participants and circumstances behind some of the warrant cancellations at the Metro warehouses in Detroit since 2010 that contributed to the hugely longer queue, including some of those merry-go-round trades, the large cancellations by Goldman and JPMorgan as well as Metro's premium-sharing arrangements. And on a practical level, you have given us some of the impact already on your customers and on you. Were you surprised when you heard about these practices? Mr. Madden. I was kind of surprised, but not entirely. I would say it equated with our worst fears of what could be happening, because this behavior of massive cancellations is unprecedented. And you asked that question earlier. I know of no occurrence in history at the aluminum--since the LME started trading in 1978, which is when I started working in the industry, I know of no precedent. So, yes, this surprised--the actual activity surprised us. But am I completely--something strange was going on, but it was very opaque to us because all these transactions happened in a non-reported way. Senator Levin. Well, were you horrified by what you saw? Mr. Madden. Well, it makes us look naive; being the biggest buyer in the world, we did not know this was going on. But we do believe that the activity was definitely prolonging the queue, and we do believe absolutely that there is a direct linkage between the premium and the queue, and, therefore, we think this issue--and this is what we have been kind of talking publicly about for the last 3\1/2\ years, that the issue around Detroit--and now it has moved to Vlissingen in Europe as well-- is pushing up premiums to levels never seen in history. Senator Levin. Now, Mr. Vazquez, if you can tell us in your judgment the relationship--two relationships: First, between the length of the queue in a warehouse and the premium, what is the relationship between the premium and the so-called all-in price? Those two things, first between the queue and the premium, and then between the length of the queue and the overall all-in price. Sometimes I call it ``market price.'' I guess it is somewhat different from market price, but for most intents and purposes, market price. Mr. Vazquez. Our work, our mathematical work, our empirical tests are really clear to indicate that queue length determines or impacts greatly the premium. And not only there is a strong correlation between the length of the queue and the premium, but there is causation, meaning mathematically, econometrically, the queue causes the premium. And the reason for that is that---- Senator Levin. When you say ``causes''---- Mr. Vazquez. Yes, causes. Senator Levin. It is a part of the premium. Mr. Vazquez. Yes. Senator Levin. Or has a direct relationship to the length? Mr. Vazquez. Yes. It is both, yes. Not only there is a correlation, because sometimes there are two variables that may be correlated, but they are not really--one does not cause the other. But in the case of the queue and in the case of the premium, not only there is correlation but there is causation, meaning---- Senator Levin. Why is that? Mr. Vazquez. Because the premium is the full logistical cost of sourcing metal. When a consumer or a buyer looks to buy metal, they have three options: They can go to the trader, they can go to the smelter, or they can go to the LME. How much it costs to move the metal all the way from the smelter to the consumer plant is an important factor behind the premium. The full logistical cost of moving metal from the trader's warehouse to the consumer's warehouse also impacts the premium. And the full cost of buying a warrant, canceling the warrant, paying storage fees, paying the FOT charge, which means how much you pay to load out the metal and put it in a truck, and then from there to your own warehouse, to the consumer warehouse, is another important logistical cost. So the combination of these logistical costs determine the premium. So the backup that the consumer has is the LME. That is the market of last resort. If the trader or the producer is charging too much in terms of premium, the consumer can go to the LME and source the metal himself, paying storage. But if the backup has a prohibitive cost, if the queue is so long that you have to pay, like today, 665 days of rent, then the trader and the producer know that your option is not really an option, and it is too expensive. So the point of reference, the point of negotiation goes up. In the past, when queues were less than 2 weeks or were less than 30 days, the consumer, whenever they were negotiating with the trader and the producer, said, ``You want to charge me so much for premium? Forget it. I can go to the warehouse and source it myself. And the equivalent cost is such that it is cheaper than what you are charging me.'' So the consumer has always used the LME as a leverage, as a point of reference when negotiating with the producer and the trader. But if you take that away, then the trader and the producer can charge at least what is the cost for the consumer to load out the metal from the LME warehouse into his plant. So that is the backup that the consumer has. Senator Levin. Goldman is arguing that when the premium goes up, the LME price goes down because the all-in price will always be about the same. That is their argument. If you buy it---- Mr. Vazquez. Senator, evidence tells us the opposite. Why the opposite? There is no clear, robust empirical data that tells us that the LME moves inversely to the premium. They move in tandem. There is no--the LME price impacts the all-in price. The premium impacts the all-in price. There is no objective data, analysis, that tells us that the LME falls when the premium goes up. Quite the opposite. Senator Levin. Before I turn it over to Senator McCain, do you agree with that, Mr. Madden? Mr. Madden. I do. Senator Levin. That the argument of Goldman that when the premium goes up, the LME price goes down because the all-in price always stays about the same--you just do not buy that? Mr. Madden. No, I do not. I can think of a parallel in history, so the last time we saw stocks at the levels we have today was in the early 1990's after the collapse of the Soviet Union, and lots of metal flooded out of Russia into the United States, and so on. At that point the LME price was down at $1,070 a ton at the low point. And the Midwest Premium was between 0 and half a cent. So when the demand is very weak or there is so much oversupply, you would expect both the premium and the underlying price to be weak. What we have today is, as I said, the highest stocks in history, and, therefore, one would expect the fundamentals are not great. But we have the highest premiums ever in history. There is no parallel, there is no time ever in the history of this market that we have seen a Midwest Premium of 23 cents, and historically it ranged from 0 to 7 cents a pound. So this is a whole new phenomenon that we are trying to get to grips with. Senator Levin. Thank you. Senator McCain. Senator McCain. So as a followup, it probably would not be possible, could it, unless one company or corporation had 85-- as Goldman Sachs does, controlled 85 percent of the LME aluminum in the United States. I do not see how you can draw any other conclusion. Is that yours? Mr. Vazquez. Yes, it is. See, it is really difficult to move the LME price, to manipulate the LME. But the volumes that move the premium, 100,000 tons under current conditions can move the premium. It is much easier to move the premium than to move the LME price. And if you have 85 percent of the volume that is in North America within LME warehouses, well, that is an interesting data point to observe. Senator McCain. Something that really is startling about this to me that has really made an impression during the course of this hearing: Why would anyone that is interested in service to the customer and a product at the lowest price, why would that organization, in this case Metro, pay its clients to move metal from one Metro warehouse into another warehouse, which sometimes is a mile away? What could possibly logically, if you are trying to do any--impose any efficiencies, why would you want to pay people so that you can move it from one warehouse to another? Please, maybe for the record, you can explain that practice, which I think is called ``merry-go-round deals.'' Maybe you, Mr. Madden? Mr. Madden. Yes, I mean, I read about this first in David Kocieniewski's article in the New York Times, and I honestly did not really understand what he was saying at that point. And now I see it in black and white, I understand. And I can only assume that if it was my business, I want to keep hold of that metal in any way I can because it is generating rent. But I also have to satisfy the LME obligation. Now, this is my theory because I do not actually know exactly what the driver is, but my theory would be if I make metal move out at the LME rate but it does not really move out, it just goes somewhere else, and then ultimately gets re- warranted, I have retained control of that pool of metal and, therefore, I can continue to count on rent provided there is a queue. And so if I can then---- Senator McCain. So you are going to make--even though you are paying your client to move their product from one warehouse to another, you are still going to make more money that would be more than the amount you are paying your client. And so ultimately all that cost is borne by the consumer sooner or later. Do you want to add to that, Mr. Vazquez? Mr. Vazquez. Yes, the reason why there is an incentive for a warehousing company to make sure that the metal comes back to the LME warehouse that they operate is because they can make more money off of it. And, of course, they want to keep the critical mass of metal because having the critical mass of metal keeps this business model going on. Senator McCain. That is why you want 85 percent of the supply. If that was not the case, then obviously this practice would be non-productive. Now, again for the record--and let us assume that there are some complexities here--there is now a 670-day waiting time from the time that a consumer orders the product, the aluminum, to the time that it would get to that consumer. Is that correct? Mr. Vazquez. Correct. Senator McCain. One more time, explain how that has ballooned from--what was it, 30 days? I think something like that. Explain to me how that happens for the record, again. I apologize if it is repetitious, but it is staggering to think that 600 days would elapse between the time you order something that is in a warehouse in the United States of America and it gets to the consumer or the user. Mr. Vazquez. Well, the size of the cancellations are completely unprecedented. And, the size of the exit door is too small compared to the size of the volume of the metal in the warehouse. That is the second reason. And the third reason, in my opinion, is that the system was not designed to make sure that no critical mass of metal could be concentrated in one warehousing company without having the proper exit door if the time for need for that metal came. So that is my reflection. That is my opinion. The exit door was not appropriate, the system was not appropriate to make sure this did not happen. Senator McCain. And, obviously, the LME does not seem to feel it necessary to take some action, apparently. Mr. Madden, do you want to add anything to that? Mr. Madden. Yes, I would be happy to. So we have talked to the LME a lot. I am a member of the LME Aluminum Committee, and the Physical Market Committee which was introduced very recently when they changed the rules, and I see, too, a shift change in the LME leadership. So the business was acquired at the end of 2013--2012, excuse me, by the Hong Kong Exchange. Prior to that, it was owned by--and I think it was mentioned earlier. It was owned by the members. So, for instance, some of the investment banks that are talking here today and tomorrow were actually significant shareholders of the LME with shareholdings of around 10 percent each. So the company was kind of regulating, managing itself, so a major change in a policy--like we were pressing for them to move the load-out rate to 9,000 or 10,000 tons a day for a warehouse like Detroit. They were very reluctant to move it. In the end, they conducted an inquiry by European Economics. They got recommendations, and they chose to take what I would say is one of the softer options. We then became--complained about it in the press and so on. So they were extremely slow to react. Since the changeover, I see a complete change of mind-set for them because the new investors have paid a lot of money for that exchange, and its reputation is being dragged through the mud. It is losing credibility all the time because of this loss of convergence in the market in the physical delivery points like Vlissingen and Detroit. So I see a kind of energy now developing in the LME to change rules, but when they do try and make a move, they get sued. So they tried to introduce a new load-out rate which would more equalize the inputs and outputs, which today would not make any difference, in all honesty, but in the future we would be less likely to see this recur. But Rusal, an aluminum company--because what a lot of people do not realize is that one of the major beneficiaries of this are the aluminum producers themselves as well as the banks and the trading companies. Rusal sued them because they tried to block the change. And I think the LME's mind-set now is it is really difficult for us to introduce new rules because whatever we do, there is going to be a stakeholder with some vested interest who is going to take action against us. Senator McCain. So what is your recommendation? I think this problem has been pretty graphically demonstrated, Mr. Chairman. What is your fix? We will start with you, Mr. Vazquez. Mr. Vazquez. I think the exchange needs help, needs a higher authority to help the exchange make sure---- Senator McCain. What about the SEC getting involved? Mr. Vazquez. I just think that we need a higher authority. It could be the solution, because I do see a change in attitude from the exchange, a clear change of attitude, a positive change of attitude. But it seems to me that they lack the authority to move as fast and as decisively and effectively as I think they should. Senator McCain. Well, is one of the answers that no one entity should control 85 percent of the supply? For the record. Mr. Vazquez. Yes. Senator McCain. Mr. Madden. Mr. Madden. Yes, I agree with Jorge. I think the LME needs help. It needs regulatory help to help it implement what I know it believes to be healthy changes in the market and probably the most--the one I mentioned which I think is the most helpful is to ban the charging of rents once a warrant is canceled, or at least within some reasonable period, 30 days. Senator McCain. Don't you think there is a regulation that if someone is moving a commodity from one warehouse to another and paying the owner of that commodity in order to do so, doesn't this border on manipulation of the market? Mr. Madden. It is difficult to comment because it is kind of new information. I think it is a day old. But it is an extremely imaginative approach to maintaining a profitable warehouse company, is to not allow stuff to leave. I think they are able to take advantage of the LME rules. They are able to use the minimum rate as a maximum. Senator McCain. And it eventually drives the price of aluminum up. Mr. Madden. Absolutely. Senator McCain. Which then drives up the cost of anything in an aluminum container. Mr. Madden. Absolutely. Senator McCain. So we are really talking about who really pays the price here is the consumer. Mr. Madden. Ultimately. Senator McCain. Well, I want to thank you for your testimony. I think it has been extremely helpful, Mr. Chairman, and it made this situation, I think, a lot more clear for the record. And I thank the witnesses. Thank you, Mr. Chairman. Senator Levin. Thank you. Now, in addition to the warehouse company, with these merry-go-rounds, maintaining and increasing the amount of metal in the warehouse company, getting rent, storage fees, that is the warehouse company's interest. Of course, it is owned by Goldman, so if the warehouse company does better, Goldman does better in that regard. But I am at least equally interested in what the cancellation does in terms of increasing the queue, which affects the premium, while Goldman is trading in transactions relating to aluminum. That gives them a huge opportunity, does it not, Mr. Vazquez? Mr. Vazquez. Yes, if you really know the market, you know that if you cancel massive amounts of metal, the queue is going to lengthen, and you know that premiums are going to go up. So if premiums go up and you have metal outside the exchange, inside the exchange, or trading derivatives, or just simply having a long position, your mark-to-market value of your overall position goes up when premiums go up. Senator Levin. And is there not something even more potent than that, as potent as that is? If you have advance information that queues are going to go up and you are engaged in trading in derivatives, which are impacted by premiums, if you have that advance information and these huge traders like Goldman thrive on information, and if they can get advance information that queues are going up longer, doesn't that give them a huge advantage in terms of their financial transactions in the market? Mr. Vazquez. Definitely, knowing that there is going to be not only a big cancellation but a set of cancellations of important volumes, if you know that ahead of time, definitely that has a benefit. Senator Levin. And when Goldman employees on that board, that warehouse board, are involved in decisions on cancellations and know there are contracts, which are not public, that require cancellations, from the warehouse perspective that maintains the amount of metal in the warehouse; but from a trader perspective, to know in advance that agreements are being entered into, which, if lived up to, require cancellations, and that means longer queues, and that means greater premiums, is that information not of huge benefit to a trading company that deals in derivatives and in futures? Mr. Vazquez. I believe so. Senator Levin. Do you agree with that, Mr. Madden? Mr. Madden. Yes, and it is kind of ironic if you think about the theory that they profess, that the all-in price does not really change, and, therefore, then you would know to short the LME if you are going to increase the queue because the higher Midwest Premium would mean the LME had to go down. So you are absolutely right. Whatever you believe, if you are aware that the queue is going to lengthen, you know the premium is going to strengthen. But I think the real benefit is, of course, on all the other aluminum they own. So there is a rent, but then when they crystallize the value of the metal that they own, however, the $3 billion worth of metal, because that is where all that value is being created, because the value of it is going up all the time, because the LME component would be hedged, except the only opportunity for price appreciation and value creation will be the--it is the mark-to-market of the premium increase. Senator Levin. So there is a huge advantage here for Goldman. They own a warehouse that is putting in more and more aluminum, now what, 75 percent of whatever the LME, total aluminum in this country is in Goldman-owned warehouses. Then they have advance information about the length of the queue because they are approving contracts, working on contracts, which will require warrant cancellations, and, therefore, the length of the queue will be increased. And they have advance information on that. And now what you have added, Mr. Madden, is something which is pretty potent, too. They own a lot of aluminum. Goldman owns a lot of aluminum. And if the price of aluminum is positively impacted through all of this, if the price of aluminum itself is going to go up through those activities, then they benefit, as you call it, mark-to-market, but the value of what they own physically is also going up, so they have an advantage in their trading world, because they are dealing in derivatives and futures and have advance information on things which will happen which will affect the price of those derivatives. Mr. Madden. That is what I believe. Mr. Vazquez. Plus any physical position they may have. Senator Levin. There is some evidence here that this warehouse company shared premium payments with a metal owner when the metal is delivered to the physical market, so that the premium payments themselves are shared with the metal owner. Is that permitted by the LME, do you know? Mr. Madden. I do not know. Senator Levin. OK. This is Exhibit 32.\1\ This was a page, and I will read it to you. If you were here earlier--and I think you were--you would have heard me read from this. It is the management brief which was supplied to Metro board members, all of whom are Goldman employees. And if you look at that management brief that was presented, it said the following: ``Extraordinary income from counterparties sharing physical premium with Metro''--in other words, they were making additional income from the counterparties sharing that physical premium, but this is something that 13 agreements in the United States Metro shared in a fee that was tied to the premium--which would give Metro another incentive to lengthen the queue, by the way, if that is the case, which it was. --------------------------------------------------------------------------- \1\ See Exhibit No. 32, which appears in the Appendix on page 1063. --------------------------------------------------------------------------- You have given us, I think, a number of suggestions as to how to end this situation. Mr. Madden, I believe you gave us three. One was that the CFTC should be able to cover this market, I believe. Are you going to weigh in on that with the CFTC? Mr. Madden. We have already. Senator Levin. OK. Mr. Madden. And I was pleased that they did take action--I cannot remember precisely when--and requested the warehousing companies and the producers who have been supplying the trading company to freeze correspondence and make it available. So they did actually assert themselves. Senator Levin. But they have not acted yet except to tell people to freeze your correspondence. Is that right? Mr. Madden. I do not know what they did subsequently. That was not public, yes. Senator Levin. OK. I want to ask just a few questions about the so-called information barrier requirements. These are not law. They are policy, and that means they are left up to the companies to implement, and these companies have a financial interest which runs the opposite direction from preventing themselves from getting information. Mr. Vazquez, could a trading company like Goldman that is in a position to approve a warehouse company's budget for freight incentives or rent discounts use that to improve its trading position in transactions relating to aluminum? Mr. Vazquez. I believe so. Senator Levin. And do you have an opinion on that, Mr. Madden? Mr. Madden. I mean, it is not where we operate, but I have to believe it creates an opportunity. Senator Levin. I will not ask you to look at it because I will quote from it. I think there has been enough said about it already. Exhibit 36d\2\ is a March 2013 packet which was given to the Metro board of directors, and here is what it provides. It provides projected freight incentives and real discounts. So the Metro board of directors is given projections of incentives, subsidies, and rent discounts. Is that information commercially valuable? Would a trader want to know if you are trading in metals? --------------------------------------------------------------------------- \2\ See Exhibit No. 36d, which appears in the Appendix on page 1157. --------------------------------------------------------------------------- Mr. Vazquez. Yes, definitely. The more information you have, the better for your trading strategy. Senator Levin. And the amount of metal coming in or out of a warehouse, would that be valuable to a trader? Mr. Vazquez. It definitely is something you would like to know in terms of trading spreads, and also in terms of trading warrants. See, there are different types of metal coming in in terms of the purity, the quality of the metal. Knowing from what smelter the metal is coming and what trader is bringing the metal, it is also information that is valuable to know. Senator Levin. Would you agree with that, Mr. Madden? Mr. Madden. Yes. Senator Levin. Well, we thank you both very much for your testimony. It has been very powerful testimony. And where we are, we are going to adjourn here for 45 minutes or until after the votes are finished in the Senate. We hope it would be no later than an hour from now. But where we are at this point in the hearing is that what we have seen very clearly is, after Goldman bought Metro, the freight incentives tripled; merry-go- round deals were done for the first time; queues went from 40 days to 665 days; the premium tripled; Metro profited, Goldman profited; and consumers lost out. That is where we are at. We will pick this up with our third panel at--it is 1:30 now. The votes are now starting at 2 o'clock. We are going to shoot for 2:45. We are going to adjourn until 2:45. I hope everybody will let their Senators know and let the public know and all of our witnesses who are on the third panel know. We thank all of our witnesses. It has been a very useful morning and early afternoon. We thank you two specifically for coming in to help us. Mr. Vazquez. Thank you, Chairman. Mr. Madden. Thank you, Chairman. [Whereupon, at 1:31 p.m., the Subcommittee adjourned, to reconvene at 2:45 p.m., this same day.] Senator Levin. We will come back to order, and I would now like to call our third panel of witnesses for today's hearing: Simon Greenshields, Co-Head of Global Commodities at Morgan Stanley, New York; Gregory Agran, Co-Head of Global Commodities Group at Goldman Sachs, New York; and John Anderson, Co-Head of Global Commodities at JPMorgan Chase, New York. We very much appreciate your being with us today and the cooperation with this Subcommittee in terms of providing information. Pursuant to Rule 6, all witnesses who testify before us are required to be sworn. So I would ask all of you to please stand and raise your right hand. Do you swear that the testimony you're about to give will be the truth and nothing but the truth; so help you, God? Mr. Greenshields. I do. Mr. Agran. I do. Mr. Anderson. I do. Senator Levin. Under our timing system, before the red light comes on, you will be seeing a shift from the green light to a yellow light, and that will give you an opportunity to conclude your remarks. Your written testimony will be printed in the record in its entirety. Please try to limit your oral testimony to 5 minutes. Mr. Greenshields, I think we will have you go first. TESTIMONY OF SIMON GREENSHIELDS,\1\ GLOBAL CO-HEAD OF COMMODITIES, MORGAN STANLEY, NEW YORK, NEW YORK Mr. Greenshields. Thank you, Senator. Chairman Levin and Members of the Subcommittee, my name is Simon Greenshields. Thank you for this opportunity to be here today. --------------------------------------------------------------------------- \1\ The prepared statement of Mr. Greenshields appears in the Appendix on page 268. --------------------------------------------------------------------------- I am Co-Head of the Commodities Division at Morgan Stanley. I am proud to work with an extraordinary group of professionals whose experience and expertise has helped to develop an industry-leading enterprise. Morgan Stanley has been in the commodities market for more than 30 years. We are committed to being responsible market participants, providing price risk management solutions and physical supply services to our clients and counterparties. We also believe in a strong regulatory framework and the sound management of the full spectrum of risks associated with the business. At Morgan Stanley, we put safety first, and we are dedicated to operating our business in a sound manner. I had a brief opportunity to review the Subcommittee's Report, and I look forward to studying it at length in the coming days. We already know that we can learn a lot from the work of Congress and the perspectives of our peers and regulators. At Morgan Stanley, we are focused on our core strengths-- providing intermediation, risk management and supply services-- where we believe that we can provide the most value to our clients. We are in the process of exiting some parts of our commodities business, particularly the ownership of physical assets. We believe that this approach will work best for Morgan Stanley and positions us where we think we should be in light of the evolving market conditions and regulatory expectations. We would also agree with you that regulatory guidance should be clear and that oversight should be robust, to ensure the risks undertaken in these markets are prudent and appropriately mitigated. More reporting and clarification through notice and comment rulemaking could also be helpful to promote confidence in the overall market. At Morgan Stanley, we will not take on the risk of engaging in activity unless we fully understand it and we can manage it effectively. We appreciate and want to be responsive to the feedback we receive from our regulators and other key stakeholders, and we understand the critical importance of transparency. We are in the business because we believe we are adding value responsibly. Our clients and counterparties are cooperatives, cities and corporations, ranging in size from small businesses to global enterprises. We want to help them succeed. We appreciate the hard work of your staff and look forward to responding to your questions. Senator Levin. Thank you very much, Mr. Greenshields. Mr. Agran. TESTIMONY OF GREGORY AGRAN,\1\ CO-HEAD, GLOBAL COMMODITIES GROUP, GOLDMAN SACHS & CO., NEW YORK, NEW YORK Mr. Agran. Thank you, Senator. Chairman Levin, Ranking Member McCain, and Members of the Subcommittee, my name is Gregory Agran, and I am Co-head of the Goldman Sachs commodities trading, where I have overall responsibility for the firm's trading activities. Commodity trading activities, excuse me. --------------------------------------------------------------------------- \1\ The prepared statement of Mr. Agran appears in the Appendix on page 274. --------------------------------------------------------------------------- As you know, for much of modern financial history, a close connection has existed between capital markets and commodities. The interplay between financial and physical commodity markets is crucial to determining the returns that thousands of companies earn for their products as well as the risk they bear in producing them. By one measure, almost 40 percent of the equity capitalization of the S&P 500 index has meaningful exposure to commodities. A core function for Goldman Sachs is to act as an intermediary or market maker for a range of clients. We perform this role across markets for interest rate, currency, equity, credit and commodity products, each of which we refer to as an asset class. Many of these transactions are settled financially, in which the parties make payment based on the terms of the transaction. A certain portion of these transactions are settled physically, where one party delivers an asset to the other in exchange for a payment. Depending on the asset class, the asset that is delivered may be a bond, a number of shares, or a specified volume or currency or commodity. We have been an active market maker in commodities and commodity derivatives since 1981. Though these activities involve physical commodities, they otherwise mirror our market- making and purely financial instruments. And it is in this role that we serve as a bridge between producers on the one hand, and consumers and investors on the other, whose interests and exposures offset each other but do not perfectly match. Our clients in the commodities business include many of the largest companies in the world across virtually every sector. Many of these companies, as well as several municipal and trade organizations, more than 100 in total, have been outspoken about the importance to them of having financial institutions participate in the commodity markets, including with respect to physical markets. Apart from helping clients finance their inventories or manage their risk, the Subcommittee staff has focused on specific instances in which the firm makes an investment in commodity-related areas. While this is a relatively small part of our commodities business, we do undertake extensive due diligence and risk analysis beyond just an analysis of the economic risks. This includes examining environmental impacts, legal liability, insurance considerations and even whether the business we are considering has operated under high standards of compliance. I want to briefly address three issues on which the Subcommittee staff has focused. While the significance and role of these issues are minor in the context of our overall commodities activities, I believe it is important to correct any misimpressions. First, our sales and trading in aluminum are unrelated to the firm's ownership of Metro. Metro was never integrated into our market-making business, and we maintain a strict information barrier between the two. Confidential information relating to Metro is not shared with Goldman Sachs metal sales and trading personnel. As the information we have provided to the Subcommittee confirms, there has not been a single instance where confidential information went to our metals trading personnel. Second, we have provided to you information involving uranium trading, a very small part of our business. In 2009, to provide a broader array of products to our mining company and public utility clients, we acquired Nufcor, a company that had acted as a market-maker in uranium and related financial derivatives. After extensive due diligence, we believed then and remain confident now that this activity does not present environmental risk to an entity acting in the limited capacity in which we act. In this business, our activities are limited to buying and selling unenriched uranium and entering into related financial derivatives. Of course, unenriched uranium is not a harmful radioactive substance. Moreover, we do not take physical possession of uranium; let alone transport, deliver, or process it. Finally, our ownership interest is merely reflected as book entries at highly secured depositories that are subject to substantial government oversight. Notwithstanding these various considerations, given the misconceptions about this business, we have decided to manage down Nufcor's assets to zero. Finally, I would like to address our stand-alone investment in CNR, a coal mining investment in Colombia. The acquisition of CNR arose from a pre-existing contract to purchase coal over a period of time. Notwithstanding the Subcommittee's statement regarding CNR, since Goldman Sachs made the investment, CNR has achieved the highest international standards for environmental and safety management and is the only company in the region to have done so. I would also note that the limited liability protection of the investment's corporate structure, together with the company's capable management team, ensure that our risk in relation to this investment is limited to our invested capital. We hope our extensive engagement with the Subcommittee staff over these many months has contributed to a greater understanding of the role that financial intermediation plays in the commodity markets in addition to these areas in which you have expressed an interest. I look forward to answering your questions today with that goal in mind. Senator Levin. Thank you very much, Mr. Agran. Mr. Anderson. TESTIMONY OF JOHN ANDERSON,\1\ CO-HEAD, GLOBAL COMMODITIES GROUP, JPMORGAN CHASE & CO., NEW YORK, NEW YORK Mr. Anderson. Thank you, Senator. I am John Anderson, and I serve as Co-Head of the Global Commodities Group within JPMorgan Chase. --------------------------------------------------------------------------- \1\ The prepared statement of Mr. Anderson appears in the Appendix on page 277. --------------------------------------------------------------------------- I am here to discuss the history of JPMorgan's involvement in physical commodities and the status of our ongoing divestiture of much of that business. While some of the topics identified by the Subcommittee may not be in my particular area of responsibility or expertise, I have attempted to gather the relevant information from others at the firm so that my statements today may not reflect my personal knowledge but, rather, my attempt to help the Subcommittee understand the issues. As we sit here today, much of JPMorgan's physical commodities assets and business has been sold. Last month, we closed on the sale of a large portion of the business to Mercuria Energy Group. In addition, the firm has sold and continues to sell other portions of the business to different buyers. Going forward, JPMorgan's commodities business will remain focused on a financial derivatives business; its associated physical activities will be limited to an exchange warrants business in base metals, traditional bank activities involving precious metals, and a commodities finance business that may involve taking title to physical commodities as the underlying collateral to that financing. At the outset, I think it would be helpful to explain how physical commodities fit into JPMorgan's overall customer business. The firm manages a customer-driven commodity derivatives business. JPMorgan is not a user of, or a speculative investor in, physical commodities. But, rather, as a market-maker, JPMorgan provides risk management and financing solutions to its customers. For example, an airline that needs to obtain jet fuel on a regular basis and wants to hedge its exposure to fluctuations in the price of the fuel. By offering a financial derivative to the airline, JPMorgan's commodities business delivers not only a hedge against future price fluctuations but also a predictability that allows the airline to focus on the safe operation of its business. The firm then hedges this exposure. JPMorgan's physical commodities business involving energy- related commodities expanded substantially when, at the behest of the government during the height of the financial crisis, the firm acquired a varied collection of assets from Bear Stearns. With the sudden acquisition of Bear Stearns and the later acquisition of RBS Sempra, JPMorgan received ownership interests in a small number of power plants and tolling agreements. Today, JPMorgan has divested or re-tolled all but three of these power assets. All three of these remaining power plants are passive investments and are being managed by third parties, and all three are either currently in the process of being sold or marketed for sale. I would now like to address in detail two specific issues raised by the Subcommittee. The first is JPMorgan's compliance with regulatory limits. At JPMorgan we operate our commodities business in conformity with the applicable rules, and we are in regular and ongoing dialog with our regulators about our physical commodities business. The business is supervised by two primary regulating entities--the OCC and the Federal Reserve. The OCC oversees the physical commodities activities done within the bank. The OCC requires that physical activities be only a nominal percentage, 5 percent, of the bank's overall commodities activity. These restrictions are designed to ensure that the bank only engages in physical commodities activity as hedges to its financial customer business and that only a small amount of overall activity in the bank is in the physical markets. The Federal Reserve regulates JPMorgan's physical commodities activities in bank holding company subsidiaries, outside the bank, and imposes a different 5 percent limit of its own. Whereas, the OCC imposes an activity limit, the Federal Reserve is focused on limiting the overall market risk of the company's physical inventory. JPMorgan has never reached the Federal Reserve's limit. With regard to the OCC's, and as a result of a large client-initiated trade, JPMorgan exceeded this limit in December 2011. This was and is the only time that this has happened in the roughly 20 years that that limit has been in place. JPMorgan immediately took steps to address this and was in regular communication with both the OCC and the Federal Reserve during this time. JPMorgan is and has always been committed to candor and transparency with its regulators. At no time has it been JPMorgan's intent to misrepresent the relevant facts or circumstances or to circumvent the applicable Federal Reserve or OCC limits. Finally, the Subcommittee has asked about JPMorgan's involvement with copper, including the firm's prior plans to launch an exchange-traded fund. The consideration of issuing a copper ETF was separate and apart from JPMorgan's customer-driven physical commodities business. JPMorgan did not amass a copper inventory in anticipation of the previously proposed ETF nor did it ever attempt to do so. In no uncertain terms, all of JPMorgan's copper trading is related to its customer-driven business, and it does not engage in proprietary trading in copper or any other commodity. JPMorgan considered, but never launched, a copper ETF, and there are no current plans to move forward with this product. The safety and soundness of the firm is JPMorgan's No. 1 priority. We are very proud of the various risk management practices we have in place and our capital strength and fortress-like balance sheet. I am happy to respond to any questions you may have. Thank you. Senator Levin. Thank you very much, Mr. Anderson. Mr. Agran, please turn, if you would, to Exhibit 3.\1\ --------------------------------------------------------------------------- \1\ See Exhibit No. 3, which appears in the Appendix on page 833. --------------------------------------------------------------------------- Exhibit 3 is a Goldman Sachs submission to the Federal Reserve that compares Goldman's physical commodities trading to its financial commodities trading. The document shows that in terms of total commodities activity Goldman's physical trading commodity is significantly smaller than its financial trading. For example, Goldman's crude oil trading is about 0.3 percent physical and 99.7 percent financial. Am I reading that correctly? Mr. Agran. Now which page are you on, Senator? Senator Levin. Page 2. Mr. Agran. Yes, that is correct. Senator Levin. So your financial trades relating to commodities represent a far greater percentage of your commodity activities than the trades of the physical commodities themselves. Mr. Agran. Both by volume and by revenue, Senator. Senator Levin. Now, Mr. Greenshields, would you say that Morgan Stanley's breakdown between physical and financial trading is similar; it does a lot more financial trading than physical trading? Mr. Greenshields. Yes, Senator, I would say that is accurate. Senator Levin. And, Mr. Anderson, what about JPMorgan's? Mr. Anderson. Yes, I would agree with that as well. Senator Levin. OK. Mr. Anderson, take a look at Exhibit 1h\2\ in your book. --------------------------------------------------------------------------- \2\ See Exhibit No. 1h, which appears in the Appendix on page 823. --------------------------------------------------------------------------- This chart was prepared by JPMorgan in 2011, when it owned tolling agreements with 31 power plants across the country and it also owned or leased gas storage facilities for about 78 billion cubic feet of natural gas since it was supplying natural gas to a number of those plants. Now U.S. banking law is supposed to encourage banks to concentrate on the business of banking--taking deposits, moving funds, and providing credit. And when I look at that network of power plants and natural gas storage facilities, however, it strikes me as a vast commercial industrial venture, not a banking activity. Now I am also struck by the risks involved--multiple sites where natural gas leaks, explosions or fires could occur. An analysis performed by the Federal Reserve Commodities Team in 2012 concluded that JPMorgan, as well as three other similar institutions, had insufficient capital and insurance allocated to cover potential losses from a catastrophic event. It determined that JPMorgan, as well as other financial holding companies, were from $1 billion to $15 billion short of what was needed to cover losses from a catastrophic event. I understand the Federal Reserve contacted JPMorgan to discuss how it was calculating the size of the potential losses from a catastrophic event and disagreed with assumptions that were being used by JPMorgan to a reduced projected total loss of $497 million from an oil spill down to a total of $50 million. That is a 90 percent loss in your estimate compared to theirs. Has JPMorgan since changed its loss calculation methodology, since that report, and allocated more capital and more insurance to cover potential losses from a catastrophic event? Mr. Anderson. Yes, there are lots of questions behind that, but I think you are primarily focused on the insurance and capital coverage. Is that correct? Senator Levin. Yes. Mr. Anderson. Yes, so at the time of that Fed report, I believe they did feel that the overall institution was not carrying enough operational capital against its operational risks. In terms of specific to commodities, your example of the $400 million being diversified down to $50 million for an oil spill is correct in how the calculation worked. The overall calculation recognized a potential of 4 to 5 percent--I think it was $490 million you quoted--loss from an oil spill liability, which would have been the loss if it had been a stand-alone company and actually ended up realizing that liability. When you then diversified it within the commodities business as a whole, and then further within the investment bank as a whole, it diversified down to $50 million. And I know that sounds like a small number, but this model that calculated it is driven by correlation assumptions and make sure that there is enough capital held against the largest possible event, as well as incremental capital. And the largest possible event across the investment bank was not in commodities, and I do not have the knowledge specifically as to what it was. But you followed that up by asking if we had put in additional capital since that dialog with the Federal Reserve. I know that our operational capital has almost quadrupled since that time. Senator Levin. Did the Federal examiners tell JPMorgan personnel that the methodology should change relative to an oil spill? Mr. Anderson. Yes, they specifically--most of the operational capital was calculated on a historic look-back method. So, if you had a loss in a mortgage business, it would be taken into account, for example. The oil business, because it was new to us, we had no historic losses. So we used a forward-looking model and an add- on approach to add incremental capital to our operational capital. And the Federal Reserve preferred that we not have a forward-looking model, that we use only the historic model. Senator Levin. And did you change your methodology relative to oil spills after the Federal Reserve asked you to do that? Mr. Anderson. Yes, we did. Senator Levin. Now take a look, if you would, Mr. Anderson, at Exhibit 70b.\1\ --------------------------------------------------------------------------- \1\ See Exhibit No. 70b, which appears in the Appendix on page 1555. --------------------------------------------------------------------------- This is a 2009 application filed by JPMorgan with the Federal Reserve, seeking what is called complementary authority to enter into tolling agreements with power plants. Now pages 7 and 8 is what I will be asking you about. Tolling agreements typically involve one party supplying fuel to run the power plant, paying its costs, and getting in exchange all of the power plant's electricity output, which that party would then try to sell for a profit. The 2009 application from JPMorgan indicates that its subsidiary, JPMorgan Ventures Energy Corporation--and I think the acronym for that is JPMVEC. Is that the way you guys pronounce it? Mr. Anderson. That is correct. Senator Levin. JPMVEC booked its electricity in natural gases. So this is from your own application, and this is what JPMorgan wrote: ``The complementary activities will further complement the existing business by providing JPMVEC with important market information. ``The ability to be involved in the supply end of the commodities markets through tolling agreements provides''--and these are key words--``access to information regarding the full array of actual producer and end user activity in those markets. ``The information gathered through this increased participation will help improve JPMVEC's understanding of market conditions and trends while supplying vital price and risk management information that JPMVEC can use to''--and here are some more key words--``improve its financial commodities derivative offerings.'' So this application indicates that one of the reasons that JPMorgan wanted to get into the power plant business was to increase its access to important market information in the electricity markets, including information about market conditions and trends, and vital price and risk management information. So far, would you agree with me? Mr. Anderson. Yes. Senator Levin. And then one of its stated purposes for JPMorgan's getting into the power plant business was to obtain information that it could use with respect to electricity- related financial instruments, which are traded in the financial markets. Is that true? Did I read that correctly? Mr. Anderson. I do not know what you are reading now, but I would agree with what you said. Senator Levin. That was the same line. It was the second half of the same line. Mr. Anderson. Yes, I agree. Senator Levin. OK. Now this application is not about getting information on JPMorgan's own business, which is usually what is allowed in this kind of a situation--to get information from your own business, get information on your business. This is about getting information about all those power plants spread out across the country, as shown in that chart, commercially valuable information about electricity production, congestion areas and price trends--what you call in that application, important market information, information about market conditions and trends, and vital price and risk management information--that you would then be able to obtain commercially valuable, nonpublic information. Is that correct? Mr. Anderson. I do not know whether that information would have been public or not. But the point of this application was, yes, to enable us to see with more transparency what was happening in energy markets so that we could make better prices to our market-making business and clients and provide them with incremental solutions. Senator Levin. And not just better prices but also getting that commercially valuable, nonpublic information--and it is nonpublic information in those plants before it is made public; it is something that you would have if you were managing those plants--your traders of financial instruments, could use it, that information, to trade electricity-related financial instruments like futures, swaps and options in the financial markets. Is that right? Mr. Anderson. This approval was primarily so that we could do tolling activities, which is a financial contract on, as you said, the output of power from a power plant, which would then be the firm's contract and the firm's information, and it could then use that flow and that insight into the most accurate price to provide the best prices to our market-making client franchise. Senator Levin. So not just the most accurate price, but it would give you an advantage, would it not, being in that business, too, in your dealings in financial commodities, the derivative offerings that you were involved in? You would have nonpublic information to help you in the financial commodities derivative offering world that you were engaged in. Is that a fair statement? Mr. Anderson. Via the tolls we would have private information that we could use to provide better services to our clients. Senator Levin. Not just the tolls but in those deals involving tolls, you would gain information which would help you to trade electricity-related financial instruments-- futures, swaps, options. Mr. Anderson. That is right, just in those tolls. If there was any plant ownership associated, that would not be shared with traders. It would be held as an independent passive investment. Senator Levin. What do you mean you would not share it with traders? Is there a Chinese wall there? Mr. Anderson. Yes, there is a barrier that---- Senator Levin. Is that in law? Mr. Anderson. I believe it is, as part of the merchant banking laws, that if you own an investment as a merchant banking investment you cannot operate it; you cannot pass information between the two organizations. Senator Levin. Well, most of these facilities were not owned as part of a merchant banking deal. Twenty-four of 27 were under complementary authority, first of all. Mr. Anderson. As tolls, right. Yes. Senator Levin. Second, as far as I can tell, there is no prohibition on the sharing of information, even for the merchant banking operation. Mr. Anderson. OK. Senator Levin. Should there be? Mr. Anderson. Between merchant banking and---- Senator Levin. And your people were engaged in trading. Mr. Anderson. Yes. Senator Levin. Should there be a Chinese wall? Mr. Anderson. There are Chinese walls. So we have lots of internal---- Senator Levin. No, but in this area, should there be? You said there is, and we disagree with you. Mr. Anderson. Well, there are internal Chinese walls for certain--I thought there were also legal obligations between a merchant banking investment and a trading organization. Senator Levin. I do not think there is. But my question is, in any event, should there be a legal prohibition, not just a voluntary policy adopted by a company whose economic interest runs in the opposite direction of the Chinese wall? In other words, the Chinese wall is supposed to be a detriment to the use of information. And the use of that information is very valuable to the company. So, if the Chinese wall is abided by, if there were one, it is still voluntary; it is still policy. It is not regulation, and it is not law. My question is since you thought there was such a wall, in any event, and should be such a wall--maybe I am reading too much into your words, but I sure believe there ought to be. My question to you is should it be legally prohibited to share information that is of market relevance between the operation of a company and the trading people in your company; should there be? Mr. Anderson. I, honestly, do not have an opinion. I am not a lawyer or a legal expert. So I cannot give you-- -- Senator Levin. Well, no, but you---- Mr. Anderson [continuing]. All the facts. Senator Levin. You have ethical guides, don't you? Mr. Anderson. Absolutely, yes. Senator Levin. Should you be able to use that information in the trading world? That is the question. That is an ethical question. Mr. Anderson. No, we should not, and that is why we have these internal walls and barriers, to protect from that. Senator Levin. And since you should not use it, is there any reason why we should not prohibit from being used? Mr. Anderson. Again, I cannot comment without having all the facts and being an expert in the area. Senator Levin. OK. Now the same people who get information about the physical power plant operations and place bids to supply electricity in California, for example, also trade electricity-related financial instruments in the futures and swaps financial markets. In 2013, JPMVEC was named in the FERC settlement agreement, charging JPMorgan with engaging in manipulative bidding strategies. JPMVEC traders were the ones that designed and used the manipulative strategies that produced $124 million in excessive electricity payments in California and Michigan that JPMorgan then paid back, with penalties and interest, totaling $410 million. Is that correct? Mr. Anderson. That is correct. Senator Levin. Now JPMorgan has told us it will take until 2018, another 4 years, for it to completely exit the power plant business. Why should it take 3 years? Why is it going so slow? Mr. Anderson. That is a good question. So we remain owners of three power plants today, of the 31 that were acquired from the Bear Stearns acquisition. Since that acquisition, we have been in steady disposition mode, and in fact, if you look at a graph of our business, it is in a steady decline ever since 2018. The three remaining power plans we do have are all in a sale process. One is actually contracted to sell today, another one should be under contract within the next quarter, and the third one, we are hoping next year. In terms of beyond next year, you said, we will still be in the business through 2008. We are out of the business as of last month. We do not own--we do not operate or control any of these. We do not have a financial interest in any of them. They are run--other than these three power plants that are still owned and we are trying to sell, but we do not operate those. They are run by third parties. In terms of the tolls in California that run through 2018, it is strictly a financial contract at this point. We have a toll that we are long from the original Bear Stearns acquisition and offsetting mirror tolls that make us short. So we are a credit intermediary in those transactions with no financial upside or downside from it other than if there were to be a credit default on one side. Now we would ideally like those two counterparties to face each other and JPMorgan to be able to step out from the middle, but they have asked us to stay in the middle as a credit sponsor intermediary. Senator Levin. Now I believe you told the Federal Reserve in 2011 that those three power plants, the ones you owned outright, that you would sell those three power plants and that they would be sold, I believe if I am reading this correctly, by now, essentially. Did you have an extension of time from the Federal Reserve to sell those three power plants? Did they give you an extension of time? Do you remember that? Mr. Anderson. So at the time of the Bear Stearns acquisition, we had a 2-year timeframe given to us by the Federal Reserve to hold all of these activities that were new to us at the time. We then had three possible 1-year extensions. Senator Levin. So they did give you extensions. Mr. Anderson. So they gave us extensions, yes. Senator Levin. Now as we set out in our Report, JPMorgan and its bank are subject to limits on the size of their physical commodity holdings. These are limits set by their two primary regulators--the Federal Reserve and the Office of the Comptroller of the Currency, the OCC. And that is a way to limit the risks associated with physical commodity activities. But by exploiting certain loopholes and using aggressive interpretations, often without telling regulators beforehand, JPMorgan and its bank have been able to accumulate physical commodity holdings far in excess of the limits while claiming to stay under the limits. To date, the regulators have closed some of the loopholes but not others. And so take a look, if you would, Mr. Anderson, at Exhibit 56a.\1\ --------------------------------------------------------------------------- \1\ See Exhibit No. 56a, which appears in the Appendix on page 1417. --------------------------------------------------------------------------- This is an application filed in 2005, asking for complementary authority again to engage in physical commodity activities, page 22 of that Exhibit 56a. And this is what JPMorgan wrote: If they were granted complementary authority that it was seeking, it ``commits to the board that it will limit the amount of physical commodities that it holds at any one time to 5 percent'' . . . 5 percent . . . ``of its consolidated Tier 1 capital.'' No caveats. No loopholes. Just a commitment to limit the amount of physical commodities that it holds at any one time. Do you see that line? Mr. Anderson. Yes, I do. Senator Levin. Now take a look, if you would, at Exhibit 90.\2\ --------------------------------------------------------------------------- \2\ See Exhibit No. 90, which appears in the Appendix on page 1691. --------------------------------------------------------------------------- And Exhibit 90 is an excerpt from a document that JPMorgan prepared for its quarterly meeting with the Fed. I guess the FDIC and the OCC were involved as well. So, if you look at page 2 of Exhibit 90, the page is entitled Physical Inventory Limits from the Fed and the OCC. It then lists various components of JPMorgan's physical commodity holdings as of certain dates. And in the first column under the date 9/28/12, it shows that as of that date JPMorgan had oil holdings worth $3.2 billion; tolls, which is a reference to the power plants that you have been talking about, worth $2 billion; and then some other items in a total for JPMVEC--that is your leading commodities subsidiary again--a total of $6.6 billion. Underneath that, it says its physical inventory as a percentage of Tier 1 capital is 4.5 percent. Do you see that? Mr. Anderson. Yes. Senator Levin. So that is what JPMorgan reported to the Federal Reserve as its total physical commodity holdings as of 9/28/2012. But that total excluded another number on this chart a bit further down, where it says Base Metals Held in Bank and shows $8.1 billion. That $8.1 billion of metals in the bank was bigger than all of the physical commodities held in other parts of the financial holding company, put together, because they had totaled $6.6 billion. Is that correct? Mr. Anderson. You said that we reported $6.6 billion as the total of the whole organization's physical commodities. That is slightly inaccurate. That is what we reported, as it says at the top here, of JPMVEC and non-bank subs. Senator Levin. OK. Mr. Anderson. And then separately, below it, it does report base metals in the bank, yes. Correct. Senator Levin. Oh, I am going to get to the base metals in a minute. In the meantime, the $6.6 billion was correct, right? Mr. Anderson. Yes. Senator Levin. OK. Now those numbers, both those numbers, both the $8.1 billion and $6.6 billion, excluded all copper, platinum, palladium, gold, silver and any merchant banking holdings held by either the bank or the holding company, which by the way were significant in size. So to simplify things, we asked your legal counsel for the amount of just the copper, platinum and palladium held by JPMorgan on September 28, 2012, and we were told that those holdings on that date totaled $2.7 billion. And when we add up all the three numbers--$6.6 billion, $8.1 billion, and $2.7 billion--the total is $17.4 billion, and that represents 12 percent of JPMorgan's Tier 1 capital at the time. So when JPMorgan was holding at least $17.4 billion in physical commodities, equal to nearly 12 percent of its Tier 1 capital, how could JPMorgan claim that it met its commitment to keep ``the amount of physical commodities that it holds at any one time to 5 percent of its consolidated Tier 1 capital''? Mr. Anderson. I think this report is very clear that, yes, we reported exactly what was in the VEC and non-bank chain as $6.6 billion. That represented 4.5 percent against the limit for those entities of 5 percent. You know, you are adding $8.1 billion---- Senator Levin. Well, for those entities, the limit was a total limit of physical commodities, wasn't it? Mr. Anderson. No, that is not correct. Senator Levin. The one I read, didn't I read that correctly? I asked you if I had read that correctly before--the commitment which was made. Mr. Anderson. That letter was referring to the non-bank chain. So that limit is applicable to the non-bank chain, which the Federal Reserve agrees with. The OCC has a separate limit that applies to the bank chain, and it is a different type of limit entirely. It is an activity limit, not an amount of metal you can hold or physical inventory you can hold, that might pose a risk to the bank. The only way you can hold physical commodities in the bank is as a hedge. It cannot be unhedged. You cannot have outright positions in it. So it does not pose financial risk to the bank. It is a separate limit to make sure the bank does not migrate beyond a low, minimal level of activity in commodities. Senator Levin. In the representation that you made, however, in your application here, that I read to you before, JPM Chase commits to the board that it will limit the amount of physical commodities that it holds at any one time. It did not limit it the way you just limited it. Mr. Anderson. But the rule is specifically applicable to non-bank chain. Also, in preparing for today, we talked about the Federal Reserve's knowledge of our base metals business and the inventory throughout the whole organization. And I know at the time, in 2005, they discussed--and they are probably our attorneys and maybe business people at the time--with the Fed that we had a base metals business in the bank. Senator Levin. So you are saying that prior to 2012 the Federal examiners knew that JPMorgan Chase was excluding the bank from the 5 percent limit. That is what you are representing here today? Mr. Anderson. I do not know what they knew or not. I know we had conversations about it. So I think they should have known, yes. Senator Levin. Well, I think we will hear tomorrow what we have heard already in our investigation; the Fed did not know that JPMorgan was excluding its bank's metals until December 2011, and then it found it out by accident. So you have some discussions to hold with the Fed. Mr. Anderson. Yes, that is surprising to me. As I said, we have open, transparent dialogs with our regulators on an ongoing basis and a regular basis. I, personally, have participated in quarterly meetings with both regulators in the same room for many years now, certainly prior to 2012. Senator Levin. Well, I think that is an issue which---- Mr. Anderson. OK. Senator Levin [continuing]. They are going to take up with you, I hope---- Mr. Anderson. Yes. Senator Levin [continuing]. Because that is not what we have been told and it is not what your commitment said. Your commitment did not exclude that. So you can say they knew it was excluded, but that is not what you represented in your commitment. And so a number of loopholes here are kind of taking over, and they need to be closed if the limit and JPMorgan's commitment is going to be an effective safeguard and limit size and amount of risk from physical commodity activities. Mr. Anderson. OK. Senator Levin. Let me ask Mr. Greenshields a few questions here. This is about Morgan Stanley's effort to construct a plant in Texas, designed to produce compressed natural gas that would be placed in large containers for export. In 2013 and 2014, Morgan Stanley formed three shell corporations, all with the name of Wentworth, as is shown in that chart that we are putting up here, if we can get the chart up. But it is also Exhibit 1g \1\ in your book. So you can see what chart I am referring to. --------------------------------------------------------------------------- \1\ See Exhibit No. 1g, which appears in the Appendix on page 822. --------------------------------------------------------------------------- This is the Wentworth ownership structure. The idea was to have Wentworth Companies in charge of the plant-building effort. Now if you look at Exhibit 45a,\1\ ``Application of Wentworth Gas Marketing, LLC for long-term authorization to export compressed natural gas.'' --------------------------------------------------------------------------- \1\ See Exhibit No. 45a, which appears in the Appendix on page 1307. --------------------------------------------------------------------------- That application was filed by one of the Wentworth Companies with the Department of Energy in May 2014. That is just 6 months ago or so. It was made public by the Department of Energy and became the basis of a media report in August, which is when many people, including some at the Federal Reserve, learned about the venture. The application indicates on page 1 that Wentworth Gas Marketing is seeking authority to export 60 billion cubic feet of compressed natural gas, known as CNG, over a 20-year period. Wentworth Gas Marketing, LLC is one of three Wentworth Companies formed by Morgan Stanley back in October 2013 and April 2014. And then on page 3 of that same exhibit, Wentworth's ``principal place of business'' is listed as Purchase, New York. So it is using the same address as the building that houses Morgan Stanley's Commodities Division. Am I correct so far? Mr. Greenshields. You are, Senator. Thank you. Senator Levin. Now please look now at Exhibit 47.\2\ --------------------------------------------------------------------------- \2\ See Exhibit No. 47, which appears in the Appendix on page 1364. --------------------------------------------------------------------------- This is a letter dated 9/19/2014, provided by Morgan Stanley's legal counsel, and this is responding to the Subcommittee's questions about Wentworth. And on page 5 of that exhibit, there is a list of board members for the Wentworth entities. And what that shows is that all three Wentworth Companies have the same board members, and those members are exclusively senior employees from Morgan Stanley's Commodities Group. Is that correct? Mr. Greenshields. That is correct, Senator, yes. Senator Levin. Under the column entitled Wentworth Entity Position, what is the position a person holds in Wentworth? You are listed as the Manager and President of the Wentworth entities, and it shows that you are also employed by MSCG, which is Morgan Stanley Capital Group, and that your MSCG title is Chairman, President and Chief Executive Officer. Is that right? Mr. Greenshields. That is correct, Senator. Yes. Senator Levin. The other board members listed here are the Vice President/Chief Operating Officer of Morgan Stanley's North American Power and Gas, the Vice President/Global Head of Morgan Stanley's Oil Liquids, and the Vice President/Head of Morgan Stanley's North American Power and Gas. In other words, the senior executives listed as running the Wentworth Companies are senior executives in Morgan Stanley's Commodities Division. Is that correct? Mr. Greenshields. That is correct. Senator Levin. Now if you will look again at page 5 and at page 8 of that same exhibit, it states that none of the three Wentworth Companies had employees and that all three rely upon the expertise and day-to-day involvement of employees of Morgan Stanley. This includes the breadth of the firm, including support in legal, tax, risk management and many other areas, to carry out the activities. Is that correct? Mr. Greenshields. That is correct. Senator Levin. OK. So as of September at least of this year, a couple months ago--and maybe things have changed in the last couple months: The Wentworth Companies had no employees of their own. All of their employees were Morgan Stanley employees. Morgan Stanley employees were relied on to carry out Wentworth's day- to-day activities. In addition, Wentworth had no offices of its own. Its only offices were the Morgan Stanley Commodities Division's offices in Purchase, New York. Wentworth's senior executives were the senior executives in Morgan Stanley's own Commodities Division. And so I hope you would agree that the Wentworth Corporations functioned as shell entities and that you and your staff were actually overseeing this project and managing the business. Mr. Greenshields. You are correct, Senator. It is a shell subsidiary corporation. Senator Levin. So there is no doubt, since Wentworth is a shell, that if anything goes wrong it is Morgan Stanley that is on the hook. Mr. Greenshields. It is correct that if anything went wrong. I will point out that we are selling this business, and I think we have reported that several times. In addition, this is not an operational company, Senator. Construction has not even begun. The reason it does not have any employees is that it really would be very little for these employees to do at this point. Senator Levin. But, as this, the intention was that you were going to sell this at some point. In the meantime--the question is whatever liability was incurred in the meantime, if and when you sell it--I know that is your stated intent now. But nonetheless, if anything goes wrong before that happens, if it happens, it is your company, Morgan Stanley, that would be on the hook in terms of liability. Is that correct? Mr. Greenshields. Ultimately, we accept full responsibility, Senator. Senator Levin. OK. I would like to talk for a moment, Mr. Greenshields, about Southern Star. Southern Star, founded in 1904, headquartered in Kentucky, it is the primary gas transmission and natural gas storage facility provider in certain areas of the Midwest, with approximately 6,000 miles of pipeline serving Colorado, Kansas, Missouri, Oklahoma, Texas, and Wyoming. Its pipeline system has a delivery capacity of approximately 2.4 billion cubic feet of natural gas per day, and its primary function is delivering gas to local natural gas distributors in its service areas. I understand that Southern Star is not part of the Commodities Division that you head; instead, it is a merchant banking investment held through an investment fund called Morgan Stanley Infrastructure Partners, or MSIP, located within a separate Morgan Stanley business segment called Merchant Banking and Real EState Investing Group. Infrastructure funds have become very popular at financial holding companies. They are being used to purchase commodity- related businesses all over the country and the world. They include power plants, natural gas facilities, hydroelectric dams, wind farms, and more. And Southern Star is a classic example. Morgan Stanley told the Subcommittee that Southern Star is 100 percent owned by its Infrastructure Fund in which Morgan Stanley has only about a 10 percent ownership interest. Morgan Stanley presents itself as having only a relatively small indirect ownership interest in Southern Star, but in fact, the relationship is far closer than that. Morgan Stanley gave us a chart showing, ``the complete ownership structure chart for MSIP.'' It was a bowl of spaghetti showing about 40 boxes and triangles in every direction. We are told that virtually all of them were shell entities with no employees or offices, just legal structures showing who owned what. The most important real entity, real in terms of having actual employees and offices, is Morgan Stanley Infrastructure, Inc., or MSI, which actually manages the investment fund. MSI is also a business unit within Morgan Stanley's Merchant Banking and Real EState Investing Group. MSI currently has about 37 employees, all of whom are Morgan Stanley employees. All of them work exclusively on the Morgan Stanley Infrastructure Fund's projects. So MSI, Morgan Stanley Infrastructure, is run by Morgan Stanley employees, sits in Morgan Stanley offices, decides on what the Morgan Stanley Infrastructure Fund is going to invest in. Morgan Stanley is also the largest single investor in the Infrastructure Fund, which owns 100 percent of Southern Star, which is its largest current investment. Now, Mr. Greenshields, when Morgan Stanley says it has only a 10 percent indirect interest in Southern Star, that is not really the whole story, is it? Mr. Greenshields. Senator, as you identified earlier, this is on the other side of the wall. I really know very little about this investment. Senator Levin. All right. Morgan Stanley's use of an Infrastructure Fund to raise money for and invest in commodity-related businesses like Southern Star is not unique. It is too common an approach to not take note of. But when folks are looking at what financial holding companies are doing relative to physical commodities, they too often ignore what is going on through an infrastructure or other investment fund as if those funds' activities are somehow outside of, or apart from, the financial holding company. But here, the Morgan Stanley Infrastructure Fund is located in Morgan Stanley's offices. Do you know if that is true or not? Do you know whether or not the Infrastructure Fund is located in Morgan Stanley offices? Mr. Greenshields. I believe it is, Senator, yes, in 1585. Senator Levin. Do you know whether it uses Morgan Stanley employees? Mr. Greenshields. I believe that there are directors that sit on the board, yes. Senator Levin. And do you know whether its decisions are made by Morgan Stanley employees? Mr. Greenshields. I do not know. Senator Levin. OK. Morgan Stanley has been an active trader in the natural gas market for decades. It trades natural gas at the same time it has ownership interest in Southern Star, and nonpublic information from Southern Star is provided on a regular basis to employees in the Merchant Banking and Real EState Investing Group. In your prepared statement, Mr. Greenshields, you said that you were ``not privy to MSIM's investment in Southern Star'' because MSIM is separate from the Commodities Division and is handled out of a business unit again called Merchant Banking. You also said in your prepared statement that Morgan Stanley has ``information barriers in place to prevent the transfer'' of material nonpublic information between the Commodities Division about MSIM's investment. Why isn't that information shared? Why do you have barriers to prevent the transfer of that material nonpublic information? Mr. Greenshields. There is no good reason for the Commodities Division to have that information, and if there is no good reason, we see no need to share it. Senator Levin. Well, as I said in my opening statement, the opportunity for that information to be shared and used is a real one, and banks such as yours are in the position to make full use of that information. The only barrier is a self- imposed barrier, as far as I know. Is that true? Is that just a self-imposed barrier, or is that imposed by law? Mr. Greenshields. You are correct, Senator. It is self- imposed. Senator Levin. And so that barrier can be ignored at any time, circumvented at any time, pulled down at any time. And I just think it is wrong for the public to have to rely on a voluntary policy such as that, which is not enforceable and which does not have the weight of law behind it because, obviously, the use of material nonpublic information by a commodities division from information that it got from physical commodities operations is simply unacceptable. I think you agreed that information should not be used. Is that correct? Mr. Greenshields. That is correct, Senator. We do not believe it should be. Senator Levin. And is there any reason why we should not put the weight of a regulation or a law behind that? Mr. Greenshields. I certainly would not object. I think it is something we do anyway, as we stated. So, if it were a legal requirement, I do not think Morgan Stanley would object. Senator Levin. You have no problem with our making sure that it becomes a legal requirement? Mr. Greenshields. I, personally, do not. I would have to check with my lawyers and my managers, but that will be my view. Senator Levin. Senator McCain. Senator McCain. Thank you, Mr. Chairman. Mr. Anderson, in 2012, JPMorgan paid Federal regulators $410 million to settle charges that it manipulated electricity markets in both California and the Midwest. And so recently, JPMorgan purchased large stockpiles of copper. So should we be concerned that you are going to manipulate the market the same way that you did with electricity markets in both California and the Midwest and paid $410 million to settle? Mr. Anderson. First, let me say that that whole situation was regrettable. And in hindsight, we hold our employees to the highest standards both legally and morally, and we believed we were operating within the rules. That said--or, these employees did--in hindsight, had they been in open communication with the FERC and local regulators, as we are with the OCC and Fed, we may have been able to avoid that whole situation to begin with. So it is clearly regrettable. In terms of copper, we have not amassed a large position in copper. First of all, we do not proprietarily trade copper. We have a customer-driven business that we make markets for in copper. I think the situation you are referring to was in 2010, where we built up, via our client franchise, about $1.5 billion worth of copper in the December time period, December 2010, which was fully hedged. So we were very agnostic as to the direction of prices. We did not have a financial interest in whether prices went up or down at the time. Senator McCain. Mr. Agran, Goldman's subsidiary owns and operates two coal mines in Colombia. Last year, the wives and children of mine workers led strikes that completely halted all coal mining operation for 9 months. It was reported that Goldman's subsidiary requested that the Colombian police and military remove the protesting women and children. And then there is an allegation that in the 9-month labor strike that your subsidiary paid protestors $10,000 each. Is that true? Mr. Agran. Our subsidiary paid former employees of the contractor, which was at the heart of the dispute, a settlement in order to--so that we could resume work, Senator. And we cross-referenced those employees to company payrolls, as well to either union or administrative labor membership. Senator McCain. I guess I have a question for all three of you. You know most Americans believe that you are financial houses that have made a lot of money. Clearly, in my view and probably that of most people, you are still too big to fail, but that is beside the point. And yet, why do you get into businesses like coal mines and electricity markets--that, at least in one case, has been manipulated--and copper, and all that. What is the point, I guess? And maybe you can help me out here, beginning with you, Mr. Greenshields. Mr. Greenshields. Thank you, Senator. That is a very good question. Morgan Stanley does not invest in coal mines. We do participate in the electricity market, both in the United States, and also in Europe. We provide market-making services in both financial products and physical products. And that is our primary business. Our primary business is market-making and the provision of liquidity, and we are improving--as a result of that, we are improving price transparency. So all these things we think are good things for our customer base. There have been certain circumstances where we have owned assets. We are downsizing that, however. We sold TMG, which is our storage business, and we are looking to sell other parts of our business, including the CNG business. But there are times when owning assets allows an entity such as Morgan Stanley to provide physical product to its customers, and that is the primary reason. Senator McCain. Mr. Agran. Mr. Agran. Well, similarly, we see the core market-making function that we provide in commodities analogous to the function we provide in interest rate products, foreign currencies or equities. So the basic product of risk intermediation is consistent across the asset classes, Senator. Senator McCain. So you get into situations such as happened at the two Colombian coal mines which I really do not think enhanced your image. Mr. Agran. I agree. The operational challenges at CNR are significant, Senator. That is not an investment that has been easy for us to oversee. But I think that it is important to recognize that banks provide capital. We lend. We underwrite stock and bond offerings. And in this situation, we made an investment, but ultimately, that is all it is. It is an investment in a coal mining company, Senator. We are not a coal miner. Senator McCain. Mr. Anderson. Mr. Anderson. Yes, Senator, market-making in commodities is an important service to the market as a whole. JPMorgan Chase has literally millions of customers, most of which touch or need commodities in some way, shape, or form. So to be able to provide them with hedging services, risk management services, and risk management advice, makes their financial expected outcome more solid. They can count on running the business that they are running and not have to worry about fluctuations in interest rates or foreign exchange or commodities or whatever the asset class happens to be. We have highlighted today some very regrettable activities. Our business is a people business, and people, unfortunately, make mistakes. It is important for us to fix those mistakes, to continue to emphasize a strong culture and, most importantly probably, to be open and transparent, to raise our own mistakes, to talk about them and work with our regulators to remediate them. Senator McCain. I guess you are the wrong person to ask, but it seems to me if you control between 50 and 80 percent of all the copper available on the world's leading metal exchange, I am not sure that is a good thing--that one corporation, be it maybe through a subsidiary, controls somewhere between half and four-fifths of the copper that is on the leading metal exchange. Maybe that is just a comment, but it seems to me if you have control of that much of a vital commodity--and copper certainly is that--that at least lends itself to a possible manipulation of prices. I think history shows that when one individual or company or corporation owns an overwhelming amount of whatever that is, that it does not leave it open to competition or to prevent manipulation. I think that is pretty well historically true. Mr. Anderson. I would be happy to address that if you want me to. Senator McCain. Please, go ahead. Mr. Anderson. That is a good point. I think you are referring to December 2010--the stocks in the LME system were quite low relative to global supply. So at the time, we did go through the 50 percent threshold, which at the time was less than 10 percent of global stocks. But it is important to note it was not our position. We were neutral in terms of our outright position. And it was part of our market-making business, where clients were buying a derivative, and the best hedge for the firm and the safest hedge for the firm was to buy the inventory as a hedge to that derivative. And they were only a couple weeks apart. So you can see if you go through the timeframe, within 2 weeks, we delivered against all those short derivatives contracts. We delivered our inventory, and we dropped down to, I think, around 15 percent. But that market is specifically set up to avoid the exact situation you described. The LME has lending guidance, and their lowest band is any individual that holds more than 50 to 80 percent of the LME supplies, they are then forced to lend into that market and make that copper available. The next band is 80 to 90 percent, and then the third band is 90 to 100 percent. And the lending guidance becomes more punitive the larger your position. So you are effectively forced to put the metal back into the market to make sure that the situation you are concerned about will not happen. Senator McCain. I thank you. Thank you, Mr. Chairman. Mr. Anderson. Thank you. Senator Levin. Well, we also saw an additional reason this morning, when we saw how the manipulation of a warehouse and warehouses holding aluminum, that those activities affect the value of the financial commodities that Goldman is trading. So, in addition to the holding of 50 percent or 80 percent of the copper market, and all that can lead to in terms of copper itself, where the action relative to the storage of that entity--in this morning's case, aluminum--can directly affect the premium paid for that aluminum and where there is trading that directly relates to that premium and to that LME price, you have a situation now where those two worlds are linked, even if that information does not cross that Chinese wall, by the way. And I am not going to rely on that. I happen to believe we have got to have regulations that make that Chinese wall real, in law. So it is not a piece of tissue paper that can be easily ignored and where it is difficult to prove that it has been violated. We have to have, I believe, regulations and law. And I am glad, Mr. Greenshields, at least speaking for yourself, that you would support these Chinese walls, these separations, being put into regulation or law. And I wonder, Mr. Anderson, whether you would agree with Mr. Greenshields on that. Mr. Anderson. I certainly believe information barriers are critical. Senator Levin. Do you think we have to put some law behind it or just leave it up to the voluntary policy of companies whose financial interests run exactly in the opposite direction of the wall? Mr. Anderson. I do not think they run in opposite directions. Senator Levin. Well, sure they do. Mr. Anderson. If you violate those---- Senator Levin. No, not violate, but isn't it clear that information is valuable and if you have information about shipments of whatever and if your traders have that information and, in the case of aluminum if you can directly, by your order, by your decision, that you are going to cancel warrants, that you effect directly in that case, directly, what the premium is going to be, what the line is going to be, which in turn is correlated to the premium? I mean, that is not a matter of information going through a wall. That is a matter of a decision made by a major holder of aluminum. Don't we have to put some force behind those walls? Mr. Anderson. Again, without having all the facts in how it would impact the overall organization or the U.S. financial system, I do not know that I am qualified to answer. I am happy to say the same thing that my colleague did---- Senator Levin. OK. Mr. Anderson [continuing]. That from my perspective and for my commodities business that I co-run, I would see no issue with that because we abide by the self-imposed ones anyway. So if they are legal, that would be fine as well. Senator Levin. All right. Now, Mr. Agran, let's talk about Goldman's involvement with uranium. I will not replow anymore than I already have at this morning's hearing, but let's talk about uranium. In 2009, Goldman purchased a company called Nufcor, which bought uranium from mining companies, stored it and sold it to nuclear power plants. Nufcor also traded uranium in the physical and financial markets. Nufcor was a longstanding, well-known company in the field. The internal Goldman memorandum that presented the case for buying Nufcor--and this is Exhibit 9,\1\ page 2--said that Nufcor had six employees and that Goldman would likely reduce it to two or three employees. --------------------------------------------------------------------------- \1\ See Exhibit No. 9, which appears in the Appendix on page 914. --------------------------------------------------------------------------- None of the employees who worked for Nufcor stayed with the company when Goldman bought it. So the company directed its own employees to run the business. Essentially, Nufcor became a shell operation under the complete control of Goldman employees who purchased and traded the uranium, entered into new contracts with nuclear power plants and dealt directly with the storage facilities. Now, by making Nufcor a shell company and using Goldman employees to carry out its business activities, did that not clearly increase Goldman's potential liability should a catastrophic event occur? Mr. Agran. Senator, I do not think that is the case. Nufcor is a limited liability company, Senator, and our market-making entity in uranium. And that affords the shareholders of the LLC, as all LLC structures do, certain shareholder protections. Senator Levin. Well, do you think Goldman is going to be liable for---- Mr. Agran. No, ultimately, I do not, Senator. Senator Levin. Do you think when Goldman runs a company the way it did--buys the company. Its people--everyone quits at the company. Goldman then puts the people in to run the company, and then it directs its own employees to run the business of the company. You think that that limited liability corporation called Nufcor is going to protect Goldman from liability of a catastrophic incident? Mr. Agran. One is on the employee issue. My understanding is having no employees does not compromise its status as an independent entity and that it is not unusual for LLCs to not have employees. But if I could, could I give you one example, Senator, of how I even think the market sees Nufcor and understands its LLC status? When we transact with utilities, Senator, it is not infrequent that they would ask Goldman Sachs to provide limited financial guarantees. Senator Levin. I am sure of that. Mr. Agran. Well, but what--so what that is showing is that the utilities understand that Nufcor--that Goldman is not liable to Nufcor. So, in some selective cases, we have granted guarantees for performance, financial performance on contracts. But we have not offered anyone a comprehensive guarantee on Nufcor's liabilities. Senator Levin. So there are certain circumstances at least that you would then accept Nufcor's liabilities. There are certain circumstances. Mr. Agran. The ones where we financially guaranteed them, yes. Senator Levin. Mr. Agran, would you please look at Exhibit 6\1\? --------------------------------------------------------------------------- \1\ See Exhibit No. 6, which appears in the Appendix on page 866. --------------------------------------------------------------------------- And on page 6 of that exhibit, Goldman explains to the Federal Reserve ``While there is no explicit scenario for environmental/catastrophic damage for any business line or corporate area, exposure related to participation in commodity markets primarily resides in the damage to physical assets risk category in Global Commodities.'' Now here is what you continue to say: ``Global Commodities' operation risk loss during storage and transportation of its physical commodity assets is limited to the value of those assets as catastrophic/environmental risk resides with the facility operators.'' So as recently as July of last year, Goldman had no capital allocated for a catastrophic event. Is that correct? Mr. Agran. That is incomplete. If you would like me to elaborate, I can. Senator Levin. Yes. I am just saying, do you have capital allocated? I am not talking about insurance. I am talking about capital allocated for a catastrophic event. That is my question. Mr. Agran. We have capital. Yes, we have operational risk capital at the firm, Senator. Senator Levin. For catastrophic events? Mr. Agran. Would you like me to explain our methodology because I think that is the easiest way? Senator Levin. Well, if the answer is yes, sure, or no. Either way, please explain. Mr. Agran. I will explain. Senator Levin. Without answering yes or no. Mr. Agran. No, we do not have any specific capital. So let me explain our methodology and how we arrived at that. Senator Levin. All right. Mr. Agran. We do a detailed analysis, Senator, including scenario analysis around environmental risk. And after that analysis, we concluded that the limited nature in the way that we engage in these markets and our comprehensive insurance program; we were not required to hold any additional capital to the $8 billion of operational risk capital that we already hold. Senator Levin. OK, let's take a look. Are you familiar with the concept of negligent entrustment? Mr. Agran. Vaguely, yes. Senator Levin. Well, can, as far as you know, Goldman be found liable if it negligently hires an incompetent operator, such as a mining company? Mr. Agran. Yes, if we negligently entrust commodity or operations, we could be held liable. Senator Levin. Or, a nuclear storage facility? Mr. Agran. Potentially. But, Senator, can I address the nuclear storage facility? Senator Levin. Sure. Mr. Agran. We are only transactional at six facilities. They are all highly regulated for trading unenriched uranium, which in your own letter you acknowledge is a nontoxic. And we trade it in book entry form. We do not take physical possession. We do not transport it. We do not process it. We are--our license does not even allow us to remove it from the facility if we wanted to. Senator Levin. That is OK. You have answered the point about negligent entrustment, and that is where the liability can come in, even with those limitations. Mr. Agran. Well, can I say one more thing on negligent entrustment? Senator Levin. Sure. Mr. Agran. We do have a vendor vetting process, where we are sensitive to the fact that negligent entrustment is a potential liability to us. We have a physical commodity review committee as well as a vendor vetting policy, and that allows us to become comfortable that we will not fall into that situation. Senator Levin. So I know you have vetting processes. That is always the case, but sometimes those vetting processes, when they fail, then the doctrine of negligent entrustment comes into effect. So you can be held liable if you negligently entrust someone. And believe me; if there are catastrophic accidents here, cases are going to be made. And then you have got to be in a position where you can survive those catastrophic events, and you are not in that position. But I want to go back to something which Senator McCain raised, and that is the coal mines in Colombia, owned by Goldman, operated by third parties hired by Goldman's wholly operated subsidiaries. Goldman's commodities trading arm is an exclusive marketing and sales agent for the coal produced by those mines and arranges for the sale of 100 percent of the coal. It takes about 20 percent for itself and then arranges for the sale of the other 80 percent to third parties. The mining is done pursuant to operations and plans that had to be approved by Goldman's wholly owned subsidiary. And are you saying that despite those facts, no jurisdiction, not even Colombia, or even a subdivision of such jurisdiction or any other country, could find that Goldman's wholly owned affiliate has any liability at all in the circumstances? Is that what you are saying? Mr. Agran. My understanding is, yes, the shareholder protections that are in place would insulate us from that liability. Senator Levin. Going back then to one final question and then I will end with a comment and then turn it over to Senator McCain if he has additional questions. Mr. Agran, take a look at Exhibit 4,\1\ if you would, please. --------------------------------------------------------------------------- \1\ See Exhibit No. 4, which appears in the Appendix on page 835. --------------------------------------------------------------------------- Now this is a presentation by the Goldman Commodities Division to the Goldman Board of Directors on October 28, 2011. At the last page, it says, ``Global Commodities Threat from Non-Traditional Competitors'' and then discusses some of Goldman's competitors including Glencore. And then last bullet point says something very important: Goldman Sachs may command valuation multiples for Goldman Sachs commodities similar to Glencore if--and here is the comment-- the business was able to grow physical activities unconstrained by regulation and integrated with the financial activities. And that is one of my major concerns here is the integration with financial activities of these commodities operations. In a formal presentation, it appears to state that its object is to integrate physical trading with financial trading. Am I reading that wrong? Mr. Agran. You are not reading it wrong. Senator Levin. I am going to save my closing comment. Senator McCain. No. Senator Levin. OK. When we began this investigation 2 years ago, all three of your financial holding companies were heavily involved with a wide range of commodity activities from coal mines to power plants to natural gas facilities. Now each one of you is pulling back somewhat. And I am glad that at least two of the three of you are pulling back significantly even though we have comments from the leadership of Goldman Sachs that these physical commodities are important strategic parts of Goldman Sachs' operation. So that is a very different kind of an approach than we have heard today and earlier than today from Morgan Stanley and from JPMorgan Chase. This is what the CEO of Goldman, Lloyd Blankfein, was quoted in the media as saying: The commodities--he is talking about physical commodities--is a ``core, strategic business'' for Goldman. A core, strategic business. Your other two companies here seem to be pulling back from those commodities, and I am glad to hear that. In an October 2013, earnings conference call, in response to questions from analysts, Goldman's Chief Financial Officer, Harvey Schwartz, described commodities as ``an essential business for our clients'' and said, ``We have no intention of selling our (commodities) business.'' Again, I am referring to physical commodities. At the same time, Goldman has recently sold many of its power plants, and it has put up its uranium, coal, and warehouse businesses for sale. And what are the plans, Mr. Agran, for the physical commodity activities? Why don't you give us that answer for the record, if you would? Mr. Agran. Well, I echo the statements of our executives for the core market-making activities, Senator. We see those as analogous to the other market-making activities we are engaged in at the firm. As far as purchase of physical assets within the commodities business, we have no plans to do that in the future. Senator Levin. Well, at least two of the three of these banks apparently are planning to exit the field, although somewhat gradually, that has caused so much concern, which has grown so vast, which has created such risk and which creates such potential for the manipulation of the financial markets. At the same time, we have a lot of questions about Federal regulation, as to how it has worked or not worked, relative to physical commodities and their relationship to financial commodities. We are going to hear tomorrow from those regulators to see what their reaction is to the current state of the world and how they are going to try to make this financial world of ours more safe and more fair and less free of the potential of manipulation. So we look forward. We thank you, our witnesses, all of our witnesses. We thank you again for the cooperation of your companies with our investigation in terms of providing materials. And I just want to ask my colleague, Senator McCain, if he has a closing question, and if not, we will stand adjourned until tomorrow, with thanks to all of you. [Whereupon, at 4:31 p.m., the Subcommittee was adjourned.] WALL STREET BANK INVOLVEMENT WITH PHYSICAL COMMODITIES ---------- FRIDAY, NOVEMBER 21, 2014 U.S. Senate, Permanent Subcommittee on Investigations, of the Committee on Homeland Security and Governmental Affairs, Washington, DC. The subcommittee met, pursuant to notice, at 9:36 a.m., in room SD-106, Dirksen Senate Office Building, Hon. Carl Levin, Chairman of the Subcommittee, presiding. Present: Senators Levin and McCain. Staff present: Elise J. Bean, Staff Director and Chief Counsel; Mary D. Robertson, Chief Clerk; Tyler Gellasch, Senior Counsel; Adam Henderson, Professional Staff Member; Angela Messenger, Detailee (GAO); Joel Churches, Detailee (IRS); Ahmad Sarsour, Detailee (FDIC); Tom McDonald, Law Clerk; Tiffany Eisenbise, Law Clerk; Tiffany Greaves, Law Clerk; Henry J. Kerner, Staff Director and Chief Counsel to the Minority; Michael Lueptow, Counsel to the Minority; Elise Mullen, Research Assistant to the Minority; Kyle Brosnan, Law Clerk to the Minority; Christina Bortz, Law Clerk to the Minority; and Chapin Gregor, Law Clerk to the Minority. OPENING STATEMENT OF SENATOR LEVIN Senator Levin. Good morning, everybody. This is the second day of our hearings on Wall Street bank involvement in physical commodities. Yesterday, we explored the physical commodity activities of three banks--Goldman Sachs, JPMorgan Chase, and Morgan Stanley--and heard from bank executives and also from experts who helped put those activities in context. Today we are going to explore the implications of our findings and how to get stronger protections against the abuses, real and potential, that could damage the banking industry, commodity markets, and in a worst-case scenario, the U.S. economy and U.S. taxpayers. We will also focus on how to build stronger protections against market manipulation and unfair trading by financial institutions with easy access to capital provided by the Federal Reserve, that is, by the American taxpayer. Yesterday's hearing showed that, in recent years, Goldman, JPMorgan, and Morgan Stanley have been heavily involved in a wide range of physical commodity activities and businesses, including building multi-billion-dollar stockpiles of aluminum, copper, oil, and natural gas, and running businesses like power plants, oil and gas storage and pipeline companies, and commodity warehouses. Now, when I say ``banks,'' by the way, it is shorthand to cover both federally insured banks and their holding companies. The evidence presented yesterday showed those Wall Street banks engaging in vast, complex commercial enterprises that are eroding the longstanding U.S. principle of separating banking from commerce. Yesterday's hearing also showed that at the same time the Wall Street banks were stockpiling commodities and running commodity-related businesses, they were engaging in massive transactions to buy and sell those same physical commodities, and were also trading commodity-related financial instruments like futures and swaps. The simultaneous trading of commodities in the physical and financial markets raises concerns related to market manipulation and unfair trading. In 2013, the Federal Energy Regulatory Commission fined JPMorgan $410 million after finding that JPMorgan commodity traders used power plants to execute manipulative bidding strategies that produced profits for the bank at the expense of electricity customers. We will hear more about that and other electricity manipulation cases today. Yesterday, we also heard about a warehouse company, purchased by Goldman Sachs and overseen by a board consisting entirely of Goldman employees, that manipulated its warehouse operations in a way that impacted the price of aluminum for consumers, while at the same time Goldman was trading aluminum- related financial products. The Goldman-controlled board of directors approved the merry-go-round transactions that have done much harm to consumers and aluminum markets. Yesterday's hearing also disclosed that Goldman employees were given access to valuable non-public information from the warehouse company related to aluminum, information that could have been used to benefit Goldman's aluminum trading. Both the warehouse company and Goldman had information barrier policies in place at the time, but given the recent history of banks improperly sharing information to manipulate electricity, LIBOR, and foreign exchange rates, reliance on voluntary policies at banks that have an economic interest in ignoring those policies is simply not enough protection for consumers. Finally, yesterday's hearing disclosed the extent to which physical commodity activities like uranium trading, coal mining, and oil and gas activities exposed Wall Street banks to wide-ranging and unpredictable risks, from natural disasters to mechanical malfunctions to labor unrest to volatile commodity prices. The Subcommittee's investigation and Report are not the first to expose the problems associated with Wall Street bank involvement with physical commodities. In 2010, the Federal Reserve formed its own Commodities Team to conduct a multi-year special review of the physical commodity activities of ten large banks. That special review found that the ten banks were heavily involved in a wide-ranging and expanding set of physical commodity activities and generally had insufficient capital reserves and insurance coverage. In fact, the review determined that four of the banks with the largest physical commodity activities, including the three examined by the Subcommittee, had shortfalls ranging from $1 billion to $15 billion to cover potential losses from a catastrophic event. Should even one of those banks, embedded in every corner of our economy, experience a catastrophic event for which it is unprepared, the U.S. banking system could be effected and U.S. taxpayers be forced to face another bailout. All this activity was occurring despite, as I have mentioned, a longstanding separation of banking and commercial activities and despite the potential threats to the safety and soundness of bank holding companies. The legal arguments advanced by the banks to minimize their liability risk are questionable and likely to be of little comfort in the event of a natural disaster or a catastrophic accident. The Federal Reserve should approach those arguments with skepticism and make sure that its responsibility to protect the financial system from 2008-style shocks remains paramount. Beyond the issue of risk, it is urgent that the Federal Reserve also consider the implications of these activities for the integrity of U.S. commodity markets and the prevention of market manipulation and unfair trading by Wall Street banks. Today, to address these problems, we are going to hear that the Federal Reserve has made a commitment to issue a new proposed rule in the first quarter of 2015. That is good news, although the 2012 findings of the Federal Reserve's own special review, together with our findings, make that rulemaking long overdue. The Federal Reserve is considering arguments that Wall Street banks provide hard-to-replace services in some of these areas. But the separation between banking and commerce has served markets and our economy quite well for decades. And the erosion of that barrier is clearly doing harm today. Any discussion of these physical commodities activities must begin and end with the need to protect our economy from risk, our markets from abuse, and our consumers from the effects of both. Wall Street banks with near-zero borrowing costs, thanks to easy access to Fed-provided capital, have used that advantage to elbow their way into commodities markets. Bad enough that this competitive advantage hurts traditional commercial businesses; worse that it opens the door to price and market manipulation and abusive trading based on non-public information. Today's hearing will receive testimony from Governor Daniel Tarullo, a member of the Board of Governors of the Federal Reserve. We will also hear from Larry Gasteiger, the Acting Director of Enforcement at the Federal Energy Regulatory Commission, who has had to deal directly with bank manipulation of the electricity market. On our first panel, we will hear from Professor Saule Omarova of Cornell University, one of the first legal experts to chronicle the rapid and largely underappreciated breakdown of the barrier between commercial activity and banking; and we will hear from Chiara Trabucchi of Industrial Economics, Inc., an expert in the area of financial responsibility and liability risk. The Subcommittee, based on 2 years of investigation, has recommended a series of actions to rein in excessive risk and conflicts of interest stemming from Wall Street bank involvement in physical commodities. Those recommendations include the issuance of a single, comprehensive limit on bank holding companies' exposure to physical commodities, no matter what authority is used to accumulate those holdings. They also include our recommendations narrowing the scope of the Gramm- Leach-Bliley authorities that allowed the explosion of Wall Street involvement in these activities to begin with. And they include instituting new safeguards to prevent Wall Street banks from using commercially valuable, non-public information obtained from their physical commodity activities to manipulate markets or to gain unfair trading advantages. The Subcommittee's Report and these 2 days of hearings will help provide a factual foundation for those and other reforms as the Federal Reserve, FERC, and other regulators consider new rules to protect businesses, consumers, and the economy. On a personal note, it has been a privilege for me to work with a staff that not only consistently displays knowledge, tenacity, and dedication, but that represents a true example of bipartisan cooperation. The staff of this Subcommittee, Majority and Minority, have done important and lasting work on behalf of the American people, and I am grateful for all that they have done. I can think of no better partner than Senator John McCain. His dedication to energetic, effective oversight is just one of his major contributions to the Senate and to our country that make working with him so rewarding. Senator McCain. OPENING STATEMENT OF SENATOR McCAIN Senator McCain. Thank you very much, Mr. Chairman. Thank you for your kind words. Yesterday, we heard about how large financial institutions are engaging in manipulative practices in physical commodities markets. Over 6 years after the financial crisis, these banks still think they are too big to fail. And, indeed, they probably are. And they have been taking on new risk that could lead to more bailouts by the American taxpayer through shady merry-go-round transactions and large purchases in commodities markets. These financial institutions have driven up costs for end users of materials like aluminum and ultimately hurt ordinary consumers. The banks could not have engaged in these activities without the permission of regulators. The Federal Reserve in particular has the power and the responsibility to make important changes that would prevent the sorts of abuses that have been illustrated in this hearing. While the Federal Reserve claims in its written statements that it has monitored this situation and explored possible actions, it has clearly not done enough to prevent harmful commodity activities by the banks. And the persons who ultimately are harmed by all of this, of course, is the average consumer, the average citizen, who has no knowledge, unless it paid attention to this hearing, of the extent of the manipulations that have been carried out by the largest financial institutions in America and, indeed, probably the world. I look forward to hearing from the witnesses why the Federal Reserve has allowed the problems identified by the Subcommittee to fester in our financial system and how it intends to fix them going forward. I thank you, Mr. Chairman. Senator Levin. Thank you very much, Senator McCain. And I now would like to call our first panel of witnesses for this morning's hearing: Ms. Saule Omarova, a Professor of Law at Cornell University, Ithaca, New York; and Ms. Chiara Trabucchi, a Principal at Industrial Economics, Incorporated, Cambridge, Massachusetts. We appreciate both of you being with us today. We look forward to your testimony, and pursuant to our rules, all witnesses who testify before the Subcommittee are required to be sworn, and at this time I would ask both of you please to stand and to raise your right hand. Do you swear that the testimony you are about to give to this Subcommittee will be the truth, the whole truth, and nothing but the truth, so help you, God? Ms. Omarova. I do. Ms. Trabucchi. I do. Senator Levin. We will use a timing system today. About a minute before the red light comes on, the light will change from green to yellow. That will give you an opportunity to conclude your remarks. Your written testimony will be printed in the record in its entirety. We would appreciate it if you could try to limit your oral testimony to 5 minutes. Ms. Omarova, we will have you go first. TESTIMONY OF SAULE T. OMAROVA,\1\ PROFESSOR OF LAW, CORNELL UNIVERSITY, ITHACA, NEW YORK Ms. Omarova. Chairman Levin and Senator McCain, thank you very much for an opportunity to testify here today. My written statement and prior writings lay out in sufficient detail my views on this subject, so I will keep my remarks to a few key points. --------------------------------------------------------------------------- \1\ The prepared statement of Ms. Omarova appears in the Appendix on page 282. --------------------------------------------------------------------------- I will recap briefly why, from the perspective of U.S. banking history, policy, and law, such involvement raises potentially significant concerns and, therefore, demands serious legislative and regulatory attention. I will also briefly address some of the main arguments against restricting banks' physical commodity activities typically advanced by banks themselves, their agents, and clients. Those advocating the regulatory status quo often claim that there is nothing new or special and, therefore, nothing problematic about allowing banks to run physical commodity operations. These industry advocates tend to sample episodes from ancient or medieval European or Asian history to prove that banks in general have always been natural commodity traders. This cherrypicking from foreign countries' distant past, however, is irrelevant for purposes of interpreting U.S. banking laws and regulations, which are based on the longstanding American tradition of keeping banks out of any non-banking commercial businesses. The principle of separation of banking from commerce has always been and continues to be the cornerstone of the U.S. banking financial system. This structural separation has been traditionally viewed as necessary in order to preserve the safety and soundness of the U.S. banking system by shielding banks from the risks of commercial activities, to ensure a fair and efficient flow of credit in the economy by preventing unfair competition, market manipulation, and banks' conflicts of interest, and to prevent excessive concentrations of financial and economic power. Early American bank charters were granted by State legislatures and typically prohibited chartered banks from dealing in merchandise. In 1825, New York became the first State to restrict banks' activities by statute. The National Bank Act of 1863 limited federally chartered banks' activities to those in the narrow band of ``the business of banking'' alone. The Bank Holding Company Act of 1956 extended the same principle to banks' parent companies, or bank holding companies, or BHCs, by generally limiting their activities to those closely related to banking. The passage of the Bank Holding Company Act marks the beginning of the truly relevant history for banks in commodities. Since 1956, for any U.S. banking organization, the decision to participate in the production, processing, transporting, or trading physical commodities, all purely commercial activities, has never been just a matter of their own or their clients' profitability or convenience. It is first and foremost a matter of their legal authority. In order to enter the physical commodity supply chain at any point and in any capacity, a bank or any bank affiliate has to find a specific legal or regulatory authorization to do so. And what this means is, that under U.S. law, these types of business decisions are deemed too important to be left purely to individual banks' managers and owners, and instead are fundamentally linked to broad considerations of public policy. The Gramm-Leach-Bliley Act of 1999 amended the Bank Holding Company Act to allow a subset of bank holding companies, financial holding companies, or FHCs, to expand their commercial activities subject to certain limits. As we know now, since the early 2000's, several large U.S. FHCs have availed themselves of these newly created statutory powers to grow extensive physical commodity operations. As I argued before, this trend undermines the fundamental principle of separation of banking from commerce and raises a wide range of potentially significant policy concerns with safety and soundness of financial institutions, systemic risk, potential public subsidy leakage, market integrity, consumer protection, the sheer governability of financial institutions, regulatory capacity to oversee them, and excessive concentrations of financial and economic powers. The banking industry, of course, dismisses all of these policy concerns as irrelevant. The industry's claims, however, are generally familiar. Banks make them every time they object to any attempt to regulate their activities. These arguments are typically either nonresponsive, nonsensical, or patently false. For example, the typical nonresponsive argument is that banks' commodities trading benefits their clients. Even if it were true, that argument completely ignores the fundamental question: To what extent those private benefits to individual clients stem from banks' access to public subsidy. An example of a nonsensical argument is the industry's claim that, because nothing bad has happened yet, there is no reason to worry that it might happen in the future. And, of course, this claim could have been made about the Deepwater Horizon accident up until the day it actually happened. An example of a patently false claim is an assertion that oil drilling is no different from making mortgage loans and that banks manage all of these risks perfectly well. In fact, oil is different from money, and traditional credit intermediation is different from trade intermediation. And claims of perfect risk management are questionable without specific proof, even with respect to banks' core financial activities, let alone things far outside the realm of their traditional expertise. So these are just a few examples of the banking industry's arguments, all of which essentially distract attention from the real questions and, in effect, deny the American public the answers we deserve. I urge lawmakers and regulators not to lose sight of what is really at stake in this important public policy debate. Thank you very much. Senator Levin. Thank you very much, Ms. Omarova. Ms. Trabucchi. TESTIMONY OF CHIARA TRABUCCHI,\1\ PRINCIPAL, INDUSTRIAL ECONOMICS, INCORPORATED, CAMBRIDGE, MASSACHUSETTS Ms. Trabucchi. Chairman Levin and Ranking Member McCain, thank you for the invitation to testify in today's hearing. My name is Chiara Trabucchi, and I am a Principal with Industrial Economics, Incorporated, in Cambridge, Massachusetts. My expertise relevant to this matter is in environmental risk management and financial assurance frameworks. --------------------------------------------------------------------------- \1\ The prepared statement of Ms. Trabucchi appears in the Appendix on page 302. --------------------------------------------------------------------------- My testimony focuses on the environmental and catastrophic event risks that confront businesses involved with physical commodity activities as well as mitigating strategies adopted by financial holding companies to manage these risks. My remarks today address the consequences of these companies engaging in commodity-related activities, including investments in industrial facilities such as power plants, pipelines, natural gas facilities, and refineries. Businesses involved with these types of activities face specialty or non-standard risks. Incidents documented in the public record evidence that activities involving the extraction, storage, transport, or refining of natural resources can cause several types of injury including, for example, human health effects, fatalities, ecological damage, property damage, business interruption, or surface/subsurface trespass. The means by which injury occurs often vary by commodity type; common pathways include pipeline rupture or explosion, impoundment failure, mine collapse, contaminant release, industrial accident, mechanical failure, or transport accident. History has shown that catastrophic events involving environmentally sensitive commodities can result in incident response costs and compensatory damages that exceed the market value of the commodity involved; a single environmental or catastrophic event can result in billions of dollars in incident-related expenditures. In some cases, financial impacts can exceed the available capital and financial assurances of the businesses involved, resulting in bankruptcy. Prudent risk management dictates that firms operating in these sectors establish risk mitigation strategies to mitigate and minimize the likelihood of an environmental event and, if an event should occur, have the financial resources to remain financially responsible for their actions. By doing so, the firm is better able to assure shareholders, whether public or private, that the value of their investment will not erode and, with time, will gain value. Traditional environmental financial assurance models require that risks be mitigated either directly as an expense or indirectly through third-party financial instruments, including, for example, insurance. In an effort to avoid the need for, or minimize the amount of, third-party financial assurances or committed capital, firms with business ventures in physical commodity markets may choose to employ other risk-mitigating strategies. One strategy involves reliance on the corporate veil as a legal shield. In the context of environmental risk management, this strategy involves establishing a series of holding companies whereby the facility engaged in activities directly related to the physical commodity is separated from the top- tier parent company by a series of corporate layers. It also may involve spinning off the liabilities of a physical commodity business into a shell corporation to shield the assets of the top-tier parent company. In either case, the financial holding company believes itself shielded from legacy environmental liabilities or catastrophic events occurring at the lower-level subsidiary or affiliate. A second mitigating strategy is to engage in physical commodity activities in foreign markets with less sophisticated environmental regimes than those present in the United States. In so doing, the financial holding company believes that it, and the U.S. taxpayer, is insulated from environmental risks at the foreign subsidiary. A third mitigating strategy is to undervalue expected loss scenarios. One approach, for example, is to assume that ownership of the asset or physical system will transfer to another entity prior to an environmental or catastrophic event occurring. Merchant banking investments can be held only for a limited amount of time. Thus, financial holding companies may underestimate the environmental risk exposure because the physical asset forms part of its portfolio only on a short-term or transitory basis. All of these risk-mitigating strategies can contribute to moral hazard where the financial holding company believes itself insulated from risk and, therefore, may act imprudently with respect to the nature and scope of its involvement with physical commodity-related activities. The consequential impacts of these strategies vary, but may include assigning an artificially low risk premium to environmentally risky ventures, limiting disclosure of contingent liabilities associated with environmental or catastrophic events, and delaying or avoiding needed infrastructure improvements. Any reluctance to make capital improvements can place the financial holding company at potentially greater risk of environmental and financial consequences when compared to peers that upgrade their infrastructure. It also may yield a short-term competitive advantage over market participants who do undertake long-term capital investments. Further, when the time comes to divest its merchant banking investment, the financial holding company may find it challenging to find a buyer who is willing to absorb the risk profile of potentially long-tailed legacy liabilities. To the extent the financial holding company does record a probable loss, it may assure only the lost market value of the commodities involved and not the expected value of incident response costs. Further, the company may argue that even if deemed liable for an environmental event, the amount of liability is negligible when measured against its overall capital structure. The failure to recognize the breadth of potential exposure arising from its involvement in physical commodity activities, coupled with the failure to maintain sufficient financial assurances, could compromise the stability of the financial holding company and its subsidiary depository institutions. This could lead to an inappropriate risk transfer to the public in the event the holding company and its non-banking subsidiary are unable to meet their financial obligations. To the degree the affected company is a global systemically important bank, a risk transfer of this sort may send a potentially destabilizing shock through the financial markets. The financial crisis of 2008 highlighted the speed with which a global market contagion can take effect when a large corporation undervalues its long-tailed risks. Notwithstanding the varying degrees of supervisory standards and capital ratios imposed on financial holding companies engaged in physical commodity activities, the ability of these companies to meet prescribed ratios may be immaterial if they have undervalued the long-tailed environmental risk exposure of their investments, either because they believe they will be legally insulated from liability or because they believe they are too big to fail. In the event the strength of the capital ratio is diluted and risky investments proceed because the potential financial consequences of prospective environmental liabilities are undervalued, then some or all of an unfunded liability may be left for the U.S. taxpayers to bear in the event of an environmental or catastrophic event. My written testimony further elaborates on these areas. I would be pleased to answer any questions. Thank you. Senator Levin. Thank you very much, Ms. Trabucchi. Professor Omarova, please take a look at a chart, which is Exhibit 1h,\1\ and we are going to put the chart, our larger version of it, up for everybody to see. This was a chart that was prepared by JPMorgan in 2011 when it owned or had tolling agreements with 31 power plants across the country, and also owned or leased gas storage facilities for about 78 billion cubic feet of natural gas since it was supplying natural gas to a number of those plants. --------------------------------------------------------------------------- \1\ See Exhibit No. 1h, which appears in the Appendix on page 823. --------------------------------------------------------------------------- Now, when I look at this network of power plants and natural gas storage facilities, it strikes me as a vast commercial, industrial venture, not a banking activity. How does it strike you? Ms. Omarova. Well, it strikes me as actually a terrifying picture of what is going on here. As a former banking attorney, to me this is precisely what the law did not mean to happen at all. This is a financial-industrial conglomerate, and it is not just the law itself that seems to be offended by this type of a picture. But there is a general expectation among American citizens and taxpayers that our banks are doing banking business. I talk a lot to various people, my friends, who are not necessarily banking lawyers; they have no idea about this stuff going on. They are nurses, cab drivers, and engineers. And when I tell them the research I have been conducting in the past 2 years, they are invariably shocked. And no matter what JPMorgan says about why this type of expansive network of power and other commercial activities is absolutely necessary to them in order to provide financial services to the people, I think they are missing something very important in that core, shared intuition that we all have: banks should not be doing this stuff. Senator Levin. And what about the risks, Ms. Trabucchi? Ms. Trabucchi. Well, I think when you have an organization that is this diversified where the span of it is across so much of the United States, and you are involved in physical commodity activities that are highly sophisticated in nature, and that result in highly sophisticated degrees of risk, I think it is a very dangerous proposition to have that consolidated in a portfolio where you have different actors who are not necessarily as sophisticated about how to manage those risks as they are in their inherent industry, which is finance. The environmental risk profile and the financial risk profile are inherently different, and so the tools and techniques that are used to manage environmental risks are not the same as those used to manage financial risk. Personally I think that this is a very troubling trend, and it is a recent trend. And so to the degree it continues or expands, I think the environmental risk profile will grow. Senator McCain. Mr. Chairman, could I interrupt a second? Senator Levin. Please. Senator McCain. As follow-up to that in general, as we see this expansion--in one case at one time one of these institutions owned 80 percent of the entire supply of copper that is traded on the exchanges--am I exaggerating too much when I say this is reminiscent of the days of the robber barons when the railroads were controlled by one individual? And, again, when you corner the world that traded supplies of a vital commodity, in that case copper, I was astounded by that. Maybe you could respond to that. Am I too alarmed? Ms. Omarova. Absolutely not. I am really glad you said that. That is precisely that back almost 100 years ago, this country was up in arms against: This kind of seamless wedding of money and control over raw materials and transportation and pure commerce. Right? Because we were worried about the fact that people who control money and control raw materials can control too much of our society in general. And it does not matter that today, in 2014, we appear more sophisticated, we have greater technology, and we can say, well, there are all these mathematical models that somehow make this picture less alarming. Ultimately at its core, it is just as dangerous as it was 100 years ago. Ms. Trabucchi. From my perspective, again, my background is environmental risk management and financial indemnity models. I think what is troubling is you have actors who are inherently-- that the public inherently believe are there to provide financial credit and to provide--or assist in financial assurance. And often those are the actors to whom your commodity actors go in order to help assure their risks. Now what you have is a combination of--or a concentration of activities in one sector, and so they are self-regulating. And, in my view, whenever you have self-regulation, it torques your risk profile, and you do not have the checks and balances necessary to make sure that the financial assurances map to the probable risk profile and map to the loss ratios, because the sectors are too interconnected. So when you are calculating a probable loss ratio and you are the one who is going to incur the loss, there is a moral hazard that arises. You do not have the incentive to appropriately manage your risks because you are also banking your own---- Senator McCain. Because you are not taking the risk. Ms. Trabucchi. Well, they would argue they are not taking a risk. I think that you are talking to somebody who believes---- Senator McCain. But that is what I mean. I mean there is no risk to them under this---- Ms. Trabucchi. It is a risk to the U.S. taxpayers. Senator McCain. Right. Ms. Trabucchi. The presumption is that there is a de facto public-private risk-sharing arrangement where the public has not necessarily been privy to that the arrangement. And I think that is the danger here; the inherent model of environmental law, environmental regimes, is to place environmental risk with the actor who incurs that risk and ensure that they remain financially accountable and financially responsible, not the-- -- Senator McCain. Which in this case, under their structure, they are not responsible. Ms. Trabucchi. Well, I think it is a matter for the courts. I think if there is an event---- Senator McCain. Should it be a matter for the courts, or should it be unequivocal, the responsibility? And I apologize, Mr. Chairman---- Senator Levin. No. Please. Senator McCain. But it raises up just one more question for both of you. After the terrible financial collapse of 2008, one of the commitments we all made--Republican, Democrat, administration, all of us--was that none of these institutions would ever again be too big to fail. I would like to ask your opinion. Given a lot of the information that we have just seen, have we achieved that goal or come to close to it, anywhere near it? Ms. Omarova. Well, not only did they not become smaller and less likely to fail, or come to the brink of failure, and much easier to resolve without any public bailouts, but to the contrary, particularly in this physical commodities area, they have grown much bigger. Not only are they bigger in terms of their size, but they have actually made themselves, according to them, their own advocates, indispensable not only as providers of finance but as providers of coal, jet fuel, oil, natural gas, aluminum, copper, and so on and so forth, or at least actors in the supply chain that have a lot of control over the availability of those raw materials. So, in effect, they are acquiring businesses that potentially can make them even more important to be bailed out or at least to claim they need to be bailed out, should anything happen. And it also creates new and unfamiliar, unstudied to this day, channels of transmitting risk, systemic risk, from finance into these non-financial areas and vice versa. So now, for example, if it is true that JPMorgan and Goldman Sachs are so uniquely indispensable to all of those end users out there in the real economy who need jet fuel or electricity, and suddenly something bad happens in their financial businesses--which usually seems to happen periodically--and somehow they are on the brink of a failure and there is a question, ``Should we let them fail?'' And suddenly policymakers will have to deal with the potential impact of letting them fail on those various utilities and airlines, and whoever they are. And so that to me is another factor to start doubting that the problem of ``too big to fail'' is being resolved. I think it is being exacerbated. Ms. Trabucchi. I think the precept here is they should not be allowed to be too big to fail, that when you are talking about environmental risk management and financial assurance, every actor in every industry in every function that they provide, they should remain financially accountable. And there are numerous---- Senator McCain. Do you believe that they are---- Ms. Trabucchi. Presently too big to fail? As I sit here right now, not having done a review of their specific financial holdings, I am not prepared to say with certainty one way or the other. What I will say is, again, they should not be allowed to be too big to fail. They should not be engaged in activities that are beyond their risk profile or beyond their ability to manage their risk profile. Some of the information that I read in the Subcommittee Report suggests that they do not know how to analyze or quantify probable loss scenarios, it is actually not true. There are industries specifically designed to measure and monetize risk. They are choosing not to do so. And so to the degree, I think, regulators allow them not to, then they are enabling too big to fail, and they do not need to do so. Senator McCain. Sorry for the interruption, Mr. Chairman, but I thought your line of questioning begged these additional questions. I thank you, Mr. Chairman. Senator Levin. That was very on target. As a followup of that, one of the issues here, the differences between a regular oil and gas company and the financial holding company is their capital ratio. So an oil and gas company has a capital ratio on average of 42 percent. Financial holding companies have an average capital ratio of 8 to 10 percent. Professor Omarova, tell us, what does that mean? And what is the difference? What is the significance of those numbers? Ms. Omarova. Well, when we speak of capital ratios, what we are really talking about is the amount of financing that a particular company raises from its own private owners, from its shareholders, as opposed to from creditors. So we are talking about leverage. So, for a regular oil company or a commodity company that you refer to, that ratio, that 42 percent is not necessarily dictated by law. It is the market, the free market that determines that in order for the creditors to really be willing to deal with that company, they want to see more of the financing coming from the owners as opposed to other lenders. And banks and financial institutions are very different in that respect. They can operate, and they are expected frequently to operate in their financial businesses, with a lot higher amount of leverage. That is why they are regulated. But that privilege, what it means is that financial institutions, especially banking organizations, get the public backup in case something goes wrong, and the creditors are still willing to deal with this company with low capital, right? Because they know that somehow the U.S. Government will back up those liabilities ultimately. And that is a tremendous advantage because what it means is that---- Senator Levin. The advantage to the banks. Ms. Omarova. To the bankers, of course. That is why all of the banks' clients, for example, are currently, crying that, oh, my goodness, if you kick banks out of this business, then we will have to deal with less ``creditworthy counterparties.'' What that really means is that those counterparties out there in the market do not have that kind of public subsidy, because banks should not be more creditworthy by market standards. Look at their capital levels, 8 percent versus 40 percent, right? There is no reason to think that this is a better counterparty to deal with but for the public backing that banks enjoy, and that is a tremendous advantage over other non-subsidized private companies in the market. Senator Levin. You made reference to concentration of power, and we heard yesterday about a severe concentration of power in the aluminum storage market. And here is what has happened, and I do not know if you have read the Report, but let me try to summarize it. Goldman Sachs acquired a large warehouse business in 2010 called Metro, and after Goldman acquired Metro, Metro tripled the incentives that it paid to attract aluminum to its many warehouses in the Detroit area. It paid millions of dollars in incentives to existing warehouse clients to engage in what we call ``merry-go-round deals,'' and here is the way it worked. The warehouse clients agreed to cancel what are called ``warrants.'' These are warrants of the London Metal Exchange. This lengthened the queue to get out because if the warrant is canceled, you have to then get in line to get your aluminum out of the warehouse. And then what they did was they canceled their warrants-- they were paid to do this--lengthened the queue to get aluminum out of these warehouses, and the result was the following: That the line, the queue, to remove metal from these warehouses went from 40 days to 665 days, forcing metal owners to wait nearly 2 years to get their metal out of storage. Now, what happened is that Metro built a virtual monopoly on the U.S. London Metal Exchange aluminum storage market. They captured 85 percent of the market share by 2014. The longer lines which resulted requiring that these warrants be canceled in order to get the subsidy resulted in and were correlated to the tripling of a premium for aluminum. To buy aluminum, you have to pay a premium plus a London Metal Exchange cost, but the premium is a big part of the price, and a big growing part of the price for aluminum. So Goldman owns warehouses and is directly involved in a decision to increase the line from, again, usually a few days to 600 days, which is correlated with a dramatic increase in the premium that people pay for aluminum. And at the same time, Goldman, through its financial transactions, is involved in the price of aluminum, futures for aluminum, swaps for aluminum, and they have this information because they are involved in the decision and the payment to people to effectively lengthen the line by going into queues. And there is a direct correlation between a longer line and the premium that is paid for aluminum. Now, that may sound kind of complicated, and it is. But that is the kind of concentration of power that involves market manipulation through the use of these warehouse operations. And it is information which Goldman not only is privy to, unlike anybody else, except the people running the warehouses for them, they are creating the situation themselves. It is not just knowing of information which affects the value of aluminum futures in which they are dealing. They are actually creating the situation as well as learning of the situation. And so they are involved in these merry-go-round deals, and I guess the question--they have obvious informational advantages in their derivatives trading operations. Now, did you read the Report or is this familiar enough to you now that you can give us a reaction to this? Ms. Omarova. Well, this is familiar to me enough. Of course, no one can ever claim that what Goldman Sachs is actually doing within its operations is fully well known to them, unless you are part of their operation. And I did not see yesterday's Goldman Sachs executives' testimony. I have read some reports that indicate that it was an act worth seeing. However, this is a very interesting situation that exemplifies precisely the dangers from the market integrity perspective of allowing large financial institutions that are active in creating and trading financial instruments linked to prices of commodities, on the one hand, to enter businesses in the actual physical commodity supply chain, so that they cannot only get some information from these operations but actually be able to physically move the prices. And, of course, they will tell us--and they probably did tell you yesterday--that none of that is happening, everything is absolutely cleanly separated, and they are really only doing it for the best of the society. But the reality of it is that, why would a financial institution, for example, even try to become a warehousing company? Until very recently, metals warehousing did not look like the kind of hot business that all the banks were really getting into, right? There must be a reason for them to extend themselves so that they actually own warehouses. And the reason is precisely their ability to devise and implement much more complex strategies for profiting from these prices, not only by extracting rental income from the warehousing or even by raising certain aluminum prices in certain markets, but also by perhaps engaging in very complex financial games around that stuff. And once that kind of a game starts determining what is happening in the market for aluminum, for example, that really distorts the dynamics that have been present for decades and centuries. And so everything becomes a lot more difficult to understand: Why things are happening the way they are happening. And perhaps that is part of the reason why it is so difficult for us to argue with Goldman Sachs executives on the specifics--``have you manipulated, have you not manipulated?'' But if you kind of step away from the specifics and look at what exactly is happening, it is quite clear that this is an extremely troubling trend, and it should NOT be allowed to continue. And, for example, the very fact that those ``merry-go- round'' clients are primarily financial institutions, those clients are the clients of Goldman Sachs in its capacity as a financial institution. So perhaps if it were not Goldman Sachs but some bona fide metals warehousing company that was running Metro's warehouses, that company might not have been able to create such incentives and to pay that much money to producers of aluminum to store aluminum in its warehouses, on the one hand, but also to find those types of convenient clients to engage in this merry-go-round that they can find because they deal with these hedge funds and private equity funds and whoever they are. And this is a very important factor to keep in mind when we think about the concentrations of power and the new forms of manipulation that may be taking place there. Senator Levin. Thank you. Senator McCain. Senator McCain. I think I have asked my question, Mr. Chairman, but Ms. Omarova raised this: Why would Goldman Sachs want to get in the warehouse business? That is a very interesting question, and I wonder if they have ever been in the warehouse business anywhere else in America. I thank you, Mr. Chairman. Senator Levin. Thank you. I just have one additional question, I guess, of Professor Omarova. Banks have been found to have engaged in serious manipulative conduct involving things like electricity prices and LIBOR and foreign exchange rates and more. Those same banks have access to near-zero interest rates to borrow money and lower capital requirements that almost any private sector company conducting physical commodity activities which do not have that kind of huge advantage. So cheaper credit and lower capital requirements translate into clear competitive advantages when banks start getting into commercial businesses, as you have pointed out, like power plants, oil storage facilities, coal mining, and so forth. Now, since the Federal Reserve is the source of those competitive advantages, does it have a responsibility to ensure that banks do not use those competitive advantages to engage in market manipulation or unfair trading? Ms. Omarova. The short answer is yes. The Federal Reserve absolutely has the responsibility to ensure that financial holding companies through their many commercial subsidiaries or otherwise do not conduct activities that are essentially taking unfair advantage of their access to a public subsidy system. And it is disheartening to me that the Federal Reserve has not done so, and even when the Federal Reserve actually was forced to publicly state its intent to look into this issue last year, in 2013, after some hearings in the Senate, even then their focus seems to be mostly on the safety and soundness of the financial institutions themselves. It is a very important issue, no question about that. But it is by no means the sole issue at stake here. The Bank Holding Company Act historically was adopted as an anti- monopoly, antitrust kind of an act, and that spirit of the Bank Holding Company Act needs to be upheld today in the face of these kinds of activities, these kinds of charts being shown to us here. And it is the Federal Reserve's primary responsibility to make sure that whenever a financial holding company gets into any non-financial business, that the financial company produces specific ongoing proof to the Federal Reserve, as our agent and a watchdog on behalf of the American taxpayer, that the extraordinary step of extending public backup for private companies' liabilities, stuff that we do with banking institutions, is not extended throughout the economy without the American taxpayers knowing about it. That is absolutely an important point, and that is precisely the point that to this day we have not seen addressed by the regulators or the industry. Senator Levin. Ms. Trabucchi, the three financial holding companies have all told us that they have been careful to set up their affairs so that they do not directly own or operate a physical commodity facility, and so they cannot be held liable for losses. I think Senator McCain asked a question like this yesterday about if BP were a bank, I think was the question he asked, so let me ask--it is really his question. If BP were a bank, what would be the impact on that bank of that oil spill? Ms. Trabucchi. Well, thankfully, BP is not a bank If you look at BP's recent Fiscal Year end 2013 annual report, you will see that they have recorded losses or anticipated losses of approximately $43 billion with incident-related expenses to date in the realm of approximately $25 billion. I think that the challenge you have are these financial holding companies believe that the legal shield they have instituted through a series of corporate veils, whether that corporate veil involves holding companies or shell companies or investing in subsidiaries and affiliates in foreign countries, that the legal shield is a de facto shield from financial responsibility. And I think what the Deepwater Horizon spill has shown, as well as several other incidents in the public record, is that parent companies do end up becoming financially responsible for the activities of their subsidiaries and affiliates, not simply because they are liable or not liable, but there are many other reasons why they might choose to do so. So, from a financial perspective, I think it is dangerous for financial holding companies to engage in a multiplicity of physical commodity-related activities with the presumption that there is no risk, and if there is a risk, the legal shield will protect them, and if the legal shield does not protect them, the amount is negligible and, therefore, not worthy of recording on their financials, I think that is a very dangerous prospect for the banks, and I think it is a dangerous prospect for the U.S. taxpayer. There are numerous other incidents. I think Deepwater Horizon is one with which the public is familiar. But there are many other environmental and catastrophic incidents that are billion-dollar incidents. Senator Levin. Now, during our investigation, Ms. Trabucchi, we came across some fact patterns which were unusual, to put it mildly. We found, for instance, that Morgan Stanley had used three shell companies, known as ``Wentworth,'' to build a compressed natural gas facility. Those companies had no employees or offices of their own. They were managed and run by Morgan Stanley employees. They were located in Morgan Stanley's Commodities Division's offices in Purchase, New York. Does that type of shell arrangement increase the chances that Morgan Stanley would be held liable if that plant were struck by a disaster? Ms. Trabucchi. In my opinion, yes. Senator Levin. Now, how about the situation at Goldman where it bought a uranium trading company, Nufcor, and the employees that ran the business left, Goldman employees took over running the business? Does that fact pattern increase Goldman's potential liability? Ms. Trabucchi. Assuming those employees were involved in the direct operation of the facility, then yes. Senator Levin. And what about a situation involving JPMorgan which directly owns three power plants but in each case it contracted with a third party to run the plant? Now, as a direct owner--what is your reaction to that? Ms. Trabucchi. Under various legal case precedents, if you are a direct owner or operator of a facility that has an environmental incident, you could be held directly liable for the actions of that subsidiary. I think when you are talking about contracting the activities, then it becomes a little bit more nuanced. And I think that the notion of contracting, really again it gets down to direct operations. Was one party directing the other party to operate a facility or operate activities in a certain fashion that resulted in an environmental incident? Senator Levin. Ms. Trabucchi, the financial holding companies that we have looked at have hundreds of billions, sometimes trillions of dollars in assets, and some have claimed that even a catastrophic event would not have a significant impact on their finances or their stability. But isn't it correct that most of those trillions of dollars belong to their clients and that almost all banks have capital ratios, again, of less than 10 percent, meaning that if disaster strikes, they do not have sufficient funds to deal with the fallout? Ms. Trabucchi. Yes, I think this is an interesting point and an interesting question, because I think that this is an area where you can see the most difference between financial holding companies operating in physical commodities and actual industrial actors who are familiar with the sophisticated nature of their commodity and their industry. Generally speaking, those actors who are in the physical commodity business must comply with very sophisticated environmental laws and environmental regimes that require financial assurance. And those financial assurance instruments--for example, insurance, surety bonds, potentially putting in place a trust fund--also allow for self-insurance where you can benchmark the strength of your financial statements against the facility's risk profile. What you need to do is evidence solvency and liquidity, which are often multiples of the prospective monetized risk. It is not just a measure of the size of the entity. So I think the short answer to your question is just presuming a capital ratio is sufficient to benchmark financial assurance for environmental risk is short-sighted. Senator Levin. Exhibit 6,\1\ in that document this is what Goldman said to the Federal Reserve---- --------------------------------------------------------------------------- \1\ See Exhibit No. 6, which appears in the Appendix on page 866. --------------------------------------------------------------------------- Ms. Trabucchi. I am sorry. Did you say---- Senator Levin. It is on page 6 of Exhibit 6, and I will read it, which may or may not obviate the need to find it in that huge book of exhibits. Ms. Trabucchi. OK. Senator Levin. Here is what Goldman said to the Federal Reserve: ``While there is no explicit scenario for environmental [or] catastrophic damage for any business line or corporate area, exposure related to participation in commodity markets primarily resides in the damage to physical assets risk category in Global Commodities.'' Now, then Goldman continued as follows: ``Global Commodities' operational risk loss during storage and transportation of its physical commodity assets is limited to the value of those assets as catastrophic [or] environmental risk resides with the facility operators.'' So as recently as July of last year, in other words, Goldman had no capital allocated for a catastrophic event, which is what a Goldman executive confirmed in his testimony yesterday. Do you have a reaction to that? Ms. Trabucchi. Well, I think, again, this gets back to this concept that they presume the legal shield is strong enough that it obviates them from any financial accountability or financial responsibility. And as I said, I think incidents, recent incidents in the public record evidence that a legal shield perhaps is not the best risk management strategy when you are working in the physical commodities sector. And I also think it is not a reasonable risk management strategy to presume no risk or to presume that if there were risk and it were monetized, that you are simply too big to fail and, therefore, that risk does not need to be assured. Senator Levin. Ms. Trabucchi, in your prepared testimony you talk about financial holding companies making transitory investments in commodity businesses like power plants, natural gas facilities, and oil and gas pipelines, and you also commented on that in your oral testimony. You point out that they plan to hold the investments for only a few years and are essentially betting that a catastrophic event will not take place while they own or lease the facility. How important, again, is that transitory factor? Ms. Trabucchi. Well, I actually think it is quite important because what we are talking about is forecasting probable loss scenarios. And if you are aggressively underestimating the length of time over which the loss scenario could arise because you believe you will not own the asset or you are only going to own the asset for a limited or short period of time, then I think what you effectively are doing is undervaluing your risk profile and undervaluing the dollar-denominated value that you could be required to pay in the event of an incident or to offset compensatory damages. And so I think the short answer here is that, notwithstanding the fact that these are merchant banking investments that are for a limited time period, what you really need to make sure you do is assess the forecasted probable loss scenario over the life of that physical commodity, not just the length of time you plan to own it. Senator Levin. And if they are making the bet that we just described that a catastrophic event will not take place during the time that they own or lease a facility, does it mean that it is more likely that they will not allocate sufficient capital and insurance to cover potential losses? Ms. Trabucchi. Yes. Senator Levin. And does making that bet also mean that they are less willing to dedicate the time, resources, and expertise to comply with regulatory requirements and to make expensive infrastructure investments that are needed? Ms. Trabucchi. I think those sorts of decisions are generally made based on cash-flows, and I think to the degree they are forecasting cash-flows and they are looking to maximize short-term profit targets and maximize investment returns--and, again, they do not plan to hold these assets for very long--then they are not going to want to make a long-lived investment. From their perspective it does not make economic sense. Senator Levin. And could the failure to make those infrastructure and resource investments increase the potential for a catastrophic event? Ms. Trabucchi. Yes. Senator Levin. And could the failure to make those infrastructure and resource investments also put pressure on its peers to skimp on them as well to the detriment of the public? Ms. Trabucchi. I do not know that I would say it quite in that fashion. I think what happens is their decisions to not make those investments put them at a price advantage or a competitive advantage over their peers, because, remember, their peers are working in highly regulated, highly sophisticated regimes where sometimes they have no choice; they must make the infrastructure improvement. And so if their peers are over here making those improvements, it is imputed in the cost of doing business, which influences their price targets, and you have another series of actors over here who are not operating within the regulatory regime because they believe in their legal shield or whatever their risk-mitigating strategies are, and they choose not to make those improvements, arguably, they are at a competitive advantage. They can work with their pricing differently than their peers. Senator Levin. All right. And if the peers are not required by regulation to make the improvements---- Ms. Trabucchi. Then, I think you are potentially fostering a moral hazard where it is a race to the bottom. Senator Levin. And then that would have a negative effect on the public. Ms. Trabucchi. It would increase the potential likelihood of an environmental incident and a catastrophic event, and it would also, arguably, increase the potential that there are insufficient financial assurances and, therefore, yes, the U.S. taxpayer may be left---- Senator Levin. And in an environmental situation, the public would be also worse off in that situation. Ms. Trabucchi. Correct. There is also the injury that arises that goes beyond simply the financial consequences. Senator Levin. OK. Senator Levin. Again, this goes, I guess, to Professor Omarova. The Gramm-Leach-Bliley Act contains a special grandfather clause that Goldman and Morgan Stanley have used to greatly expand their physical commodity activities. Section 4(o) of the act authorizes any company that becomes a financial holding company to continue conducting ``activities related to the trading, sale, or investment in commodities and underlying physical properties'' subject to certain conditions. A broad interpretation of this language suggests that if a financial holding company were engaged in physical commodities activities in a very limited way prior to a certain date in 1997, this section would allow them to broaden their activities into all aspects of physical commodities. That is a broad interpretation. The 1999 Senate Banking Committee Chairman offered the amendment that formed the basis for Section 4(o) and entitled it ``The amendment on grandfathering existing commodities activities.'' And the amendment also contained this short explanation: ``The above amendment assures that a securities firm currently engaged in a broad range of commodities activities as part of its traditional investment banking activities is not required to divest certain aspects of its business in order to participate in the new authorities granted under the Financial Services Modernization Act.'' This provision grandfathers existing commodities activities. Now, a grandfather clause usually protects existing conditions from a new rule. Have you ever heard of a grandfather clause used to justify completely new activities? Ms. Omarova. You are absolutely correct. Grandfathering provisions typically are enacted in order to avoid certain unnecessary hardships or disruptions of certain existing operations--so, mainly in the interest of fairness to the new company that suddenly becomes subject to a new regime--and to prevent the need for some kind of fire sale of assets. But no grandfather provision is usually conceived as a completely independent grant of some open-ended, absolutely new privilege for a financial institution that becomes now a bank holding company to engage in the future in any kind of physical commodity activity that is absolutely not allowed under the existing law. And that is precisely what a broad and very mechanical interpretation of just the language of the statute seems to say. And I also agree with you that the legislative history of this provision clearly shows that it was never meant to be something to allow Goldman Sachs and Morgan Stanley to essentially move into any physical commodities markets they want at any point in the future without any limitations. Senator Levin. Professor Omarova, in 2010 the Federal Reserve Commodities Team undertook a 2-year in-depth review of the physical commodity activities being conducted under the grandfather clause at Goldman Sachs and Morgan Stanley, and they at that time were the only financial holding companies that were using that clause. Among other measures, the review compared their activities prior to the 1997 trigger date and in 2010, and during that review a detailed status report was prepared indicating that Goldman Sachs and Morgan Stanley had used the grandfather clause to greatly expand their commodity activities and incur numerous new risks. And here is part of what the Federal Reserve's Commodity Team found. These are long findings, so bear with me. ``The scope and size of commodity-based industrial activities and trading in physical and financial commodity markets at Morgan Stanley and Goldman Sachs has increased substantially since 1997. There are a large number of new commodities traded by these firms today which they did not trade in 1997. The new commodities traded today by Morgan Stanley number 37 and Goldman Sachs, 35. ``Much of the new business conducted by Morgan Stanley and Goldman Sachs is in the form of industrial processes involving commodities. The expansion of these firms into power generation, shipping, storage, pipelines, mining, and other industrial activities has created new and increased potential liability due to the catastrophic and environmental risks associated with the broader set of industrial activities. ``And,'' the report went on, ``below are examples of industrial processes which are new or greatly expanded today from 1997: leasing of ships and ownership of shipping companies at Morgan Stanley and Goldman Sachs; new ownership and expanded leasing of oil storage facilities at Morgan Stanley; ownership of companies owning oil refineries at Morgan Stanley; ownership of coal mines and distribution at Goldman Sachs; new ownership of power plants at Goldman Sachs and expanded ownership at Morgan Stanley; leasing of power generation at Morgan Stanley and Goldman Sachs; ownership of retail gasoline outlets at Morgan Stanley; ownership of royalty interests from gold mining at Morgan Stanley; ownership and development of solar panels at Morgan Stanley. ``Furthermore,'' it went on, ``the scale of bank involvement in industrial commodity processes is not widely understood, even within the bank regulatory community. As a result, it is possible that losses within the banking sector arising from these activities will be surprising.'' Now, what is your view regarding the extent of grandfathered activities continuing, going on, after a report like that? Ms. Omarova. Well, in my view, this Section 4(o), the grandfathering of commodities activities for certain new bank holding companies, in practice, of course, the two relevant institutions to speak of are Goldman Sachs and Morgan Stanley that became subject to these laws in 2008--this section creates an enormous loophole, especially if allowed to be interpreted so broadly as to permit such an incredible expansion of activities beyond what was conceivably contemplated by Congress back in 1999 even. And so it does not surprise me at all that both Goldman Sachs and Morgan Stanley assert that there is absolutely no ambiguity in their ability to use this grandfather clause, not just to continue what was properly grandfathered but to just do anything and everything in that field. But it is the Federal Reserve's job to give some clarity on this issue, because if we just allow Goldman Sachs and Morgan Stanley to be the ultimate judges of what is permitted by this language, then, of course, we are going to see their commodity empires expand, and that creates also a competitive advantage for them vis-a-vis even other financial institutions playing in the field. Senator Levin. Would you agree that this clause should not be given a broad reading? Ms. Omarova. Absolutely, I agree with that. It should not. Senator Levin. And then if it were challenged in court against a narrow reading, which is the one you recommend, Congress could then have an opportunity to amend the language. Is that correct? Ms. Omarova. Well, I think Congress has the opportunity to amend the language anytime it wants to, and perhaps it should. Senator Levin. Without waiting for the Federal---- Ms. Omarova. Exactly. Senator Levin. Well, let us hope we do not have to do that, because we are not so adept at getting things done these days either. But the Federal Reserve is in a position where they have an obligation---- Ms. Omarova. Absolutely. Senator Levin [continuing]. To give an interpretation to this. Ms. Omarova. Absolutely. Senator Levin. By the way, do you have a view, Ms. Trabucchi, on the grandfather clause? Ms. Trabucchi. I do not. I actually think Professor Omarova captured it well. Senator Levin. Professor, as you saw in our Report, one of the key findings in our investigation is that there is no overall size limit on the amount of physical commodity assets that can be held by banks and their holding companies. We also uncovered actions taken by JPMorgan to use loopholes, exclusions, and valuation techniques to stay under the Fed's 5- percent limit, even while its physical commodity holdings were growing. As a result, as of September 28, 2012, JPMorgan had physical commodity holdings of at least $17.4 billion, equal to nearly 12 percent of its Tier 1 capital. At the same time, it was using loopholes and exclusions to report to the Federal Reserve that it had $6.6 billion, or 4.5 percent of its Tier 1 capital. It shows, that discrepancy, just how ineffective the current limits are. Now, physical commodities may be held under complementary authority, in which case they are subject to the 5-percent Tier 1 capital limit. They are authorized to be held under grandfather authority, in which case they are subject to a limit of 5 percent of total consolidated assets or under merchant banking authority, in which case they are not subject to a limit if they comply with the restrictions in that authority. None of what I have just said counts anything that is held in the bank under the authority of the OCC. So copper held as bullion is also exempt from any size limits. This seems like a patchwork of rules and limits that is subject to manipulation and leaves physical commodity activities with no effective overall limit. Should the Federal Reserve have a single, overarching limit to protect the safety and soundness of the banks and their holding companies? And do you think that the Federal Reserve has the legal authority to do that? Ms. Omarova. The findings in the report about the ongoing sort of manipulation of all of these limits in different provisions of the law are very alarming because they illustrate precisely the potential weaknesses of relying exclusively on a particular size limit and then creating additional opportunities for the financial institution to claim that a completely different size limit would apply to the same activity, for example. So that way, of course, they could take their assets, commodity assets, and put them in different little baskets, and then say, well, overall we are OK; but in reality it is not OK. So I do think that if the Federal Reserve decides to clean up its regulatory approach to limit these activities based on some kind of size or concentration, for example, then they absolutely have to seriously consider imposing one overall size limit on all of the assets, no matter under what authority they are held. Do they have authority to do so? I believe that they do because they are--especially after the adoption of the Dodd- Frank Act in 2010, the Federal Reserve is an important systemic risk regulator, and they have enormous powers and a lot of flexibility as a regulator to do what needs to be done in order to prevent the financial system from the next crisis. And this is perhaps one of those instances where such an authority should be used in order to strengthen this particular aspect of regulation. Of course, any size limit, no matter how strictly you set it, is only as good as it is complied with, as compliance with it, right? So what really is important is that the Federal Reserve elevates the level and intensity of its supervisory efforts with respect to controlling and monitoring how those financial institutions have complied. Senator Levin. So you need size limits. You need them that do not have a whole bunch of loopholes in them. You need them to be enforced. And just, I guess, for you, Ms. Trabucchi, I assume that you would agree that size limits are useful to reduce risk. Ms. Trabucchi. Yes, but I would go one step further, and I would say that it cannot just simply be a percentage of the total consolidated assets of a financial holding company. It needs to be benchmarked against the probable loss scenario and the monetized estimate of incident-related expenditures and compensatory damages that could arise. And I think it should be a multiple, and I also think it should be benchmarked against tangible assets--assets that can be actually leveraged to pay for the payment--for the expenditures of an event. Senator Levin. I just have one final question before we turn to our next panel. In 2009, in response to the financial crisis, the Federal Reserve revamped its organizational structure and created the Large Institution Supervision Coordinating Committee, whose operating committee created in turn a ``Risk Secretariat.'' The Risk Secretariat's mission is to identify key risks affecting systemically important financial institutions and provide the resources needed to conduct in-depth risk investigations. And in one of its first actions, it identified bank involvement with physical commodities as an emerging area of risk that required review. I would assume that you would both agree with that assessment. Is that accurate? Ms. Trabucchi. I would. Ms. Omarova. Yes, absolutely. Senator Levin. And that is what your testimony is all about, and that is what we are all about in these hearings, is to find out what has been going on at the Fed since 2009 when they revamped their structure, created that committee, made that finding, and what are we going to do as a people and as a government to reduce these risks and to take away these opportunities for financial manipulation? Professor, Ms. Trabucchi, thank you both very much. Thank you for the work you do in the private world. Thank you for coming here today. Ms. Trabucchi. Thank you. Ms. Omarova. Thank you. Senator Levin. I will now call our second panel: Hon. Daniel Tarullo, a Governor on the Board of Governors of the Federal Reserve System; and Larry Gasteiger, Acting Director of the Office of Enforcement at the Federal Energy Regulatory Commission, FERC. We appreciate both of you being with us today. We look forward to your testimony. And as you are aware of our rules, we ask all of our witnesses to be sworn, and we would ask you now to please stand and raise your right hand. Do you swear that the testimony you are about to give to the Subcommittee will be the truth, the whole truth, and nothing but the truth, so help you, God? Mr. Tarullo. I do. Mr. Gasteiger. I do. Senator Levin. We have a timing system, and I think you are both aware of it. A minute before the time is up, the red light will change from green to yellow and then it will be red. We would ask that you try to limit your oral testimony to no more than 10 minutes. And, Mr. Tarullo, we are going to ask that you go first. And thank you again for being here. We know the kind of schedule both of you have, including on the Hill, by the way, so thanks so much for being here. Mr. Tarullo, please proceed. TESTIMONY OF HON. DANIEL K. TARULLO,\1\ MEMBER, BOARD OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM, WASHINGTON, DC Mr. Tarullo. Well, thank you, Mr. Chairman. Before beginning my testimony, I want to offer a bit of a testimonial on what I believe is one of the last occasions on which the Chairman will wield the gavel at a Senate hearing. --------------------------------------------------------------------------- \1\ The prepared statement of Mr. Tarullo appears in the Appendix on page 313. --------------------------------------------------------------------------- I first became aware of your energy and commitment in the 1970's, reading about you in the Detroit papers, when you were president of the Detroit City Council and I was a law student living in Ann Arbor. I have watched that energy continue unabated during your six terms in the Senate right up through this set of hearings that includes today's panel. So as you retire, let me congratulate you for all your accomplishments during those 36 years. Senator Levin. Well, thank you so much. You do not look old enough to go back to my City Council days, but I am afraid I am. Thank you so much. Mr. Tarullo. So turning now to the subject of this hearing, commodities activities in bank holding companies were not, of course, the story of the recent financial crisis. But that does not mean that they pose no risks to the safety and soundness of bank holding companies. Actually, to a considerable extent, the issues surrounding such activities are a product of the crisis insofar as large, formerly freestanding investment banks with substantial commodities activities were either acquired by or converted to bank holding companies in 2008. So even as we continue to put in place regulations directed at preventing the kinds of solvency and funding troubles that gave rise to the crisis, we need also to be forward-looking and address post- crisis developments that could give rise to future problems. I might note in passing that some of these post-crisis regulatory changes that we are already in the process of enacting--notably, the increases in risk weighting for certain activities under new capital requirements--will themselves have an effect on commodities activities. Supervisory experience with these commodity activities in bank holding companies since the disappearance of the five larger formerly freestanding investment banks, along with our observation of the impact of catastrophic events involving certain commodities, led us to begin a broad review of relevant regulatory and supervisory policies. As is appropriate given our overall mandate for prudential supervision, we have focused particularly on the implications of various commodities activities for the safety and soundness of bank holding companies. We have also revisited the factors relevant to determinations made beginning more than a decade ago that certain commodities activities should be regarded as complementary to financial activities under Section 4(k)(1)(B) of the Bank Holding Company Act. The Advanced Notice of Proposed Rulemaking that we issued early this year sought public comment on these and a range of other issues, including activities conducted by bank holding companies under the merchant banking authority and Section 4(o) grandfathering provision, both of which were added in the Gramm-Leach-Bliley Act. As you might expect, the ANPR has elicited a considerable number of responses from a range of perspectives. We are nearing the end of the analysis of these comments and other information relevant to the issues raised in the ANPR. So while we do not yet have a Board proposal for specific changes in regulatory and supervisory policies, I anticipate that we will be issuing a Notice of Proposed Rulemaking in the first quarter of 2015. In closing, I would note that the Report issued by this Subcommittee on Wednesday will be an important additional input into the final stages of staff analysis and eventual Board consideration of policy changes. Thank you very much, and after my colleague gets done, I would be pleased to answer any questions you might have. Senator Levin. Thank you, Governor Tarullo. Mr. Gasteiger. TESTIMONY OF LARRY D. GASTEIGER,\1\ ACTING DIRECTOR, OFFICE OF ENFORCEMENT, FEDERAL ENERGY REGULATORY COMMISSION, WASHINGTON, DC Mr. Gasteiger. Mr. Chairman, thank you for inviting me to testify today. My name is Larry Gasteiger, and I am the Acting Director of the Office of Enforcement of the Federal Energy Regulatory Commission. I am pleased to testify regarding the Commission's enforcement program and some of its recent enforcement actions involving financial institutions. --------------------------------------------------------------------------- \1\ The prepared statement of Mr. Gasteiger appears in the Appendix on page 325. --------------------------------------------------------------------------- The Commission's statutory authority and responsibility to investigate market manipulation in FERC-jurisdictional energy markets is rooted in the Energy Policy Act of 2005, which I will also refer to as ``EPAct 2005.'' In the aftermath of the Western energy crisis and the 2003 Northeast blackout, Congress passed EPAct 2005, which broadly prohibited market manipulation in FERC-regulated wholesale physical natural gas and electric markets, and provided new authority to enforce mandatory reliability standards. Congress also significantly enhanced the Commission's civil penalty authority for violations of FERC rules by increasing maximum civil penalties to $1 million per violation per day. Since receiving its expanded enforcement authority, the Commission has worked hard to buildup its enforcement capabilities. Around the time of the Western power crisis, FERC had about 20 enforcement staff. Today we have nearly 200 attorneys, auditors, economists, analysts, and former traders working in the Office of Enforcement. In the last few years, FERC has enhanced its ability to identify price manipulation in both physical and financial markets by adding surveillance tools, expert staff, and new analytical capabilities. And in 2012, the Commission established a dedicated unit for market surveillance and analysis in the Office of Enforcement. Also in the past year, FERC surveillance and enforcement efforts have been enhanced by a new Memorandum of Understanding with the Commodity Futures Trading Commission that provides us with access to additional highly useful financial data on a regular and continuing basis. We have worked hard to effectively and efficiently put these resources to good use. Since receiving its EPAct 2005 authority, the Commission has imposed and collected approximately $902 million in civil penalties and disgorgement. Some of these enforcement actions have involved financial institutions, including JPMorgan, Deutsche Bank, and Barclays. I have provided a more detailed description of these cases in my written testimony, but, briefly, the JPMorgan case involved market manipulation in the California and Midwest energy markets and resulted in a settlement requiring JPMorgan to pay a combined $410 million in civil penalties and disgorgement in July 2013. The settlement resolved the Office of Enforcement's investigation into 12 manipulative bidding strategies that gamed the markets by creating artificial conditions that would cause the system to pay the company inflated rates. Enforcement staff also determined that JPMorgan knew that the two regional markets where these schemes played out received no benefit from making these inflated payments, and thus, the company defrauded those market operators by obtaining payments for benefits that they did not deliver. In our settlement with Deutsche Bank in January 2013, the Office of Enforcement determined that Deutsche Bank used physical energy transactions to affect congestion levels and corresponding energy prices within the California market. It carried out this conduct to increase the value of its financial contracts in violation of EPAct 2005 and the Commission's anti- manipulation rule. The disgorgement in that case was $172,000 with a penalty of $1.5 million. Then the Commission's July 2013 order assessing a civil penalty in the Barclays case addressed similar conduct to that in Deutsche Bank. The Commission found that Barclays engaged in manipulative physical trades to benefit corresponding financial positions. Though Barclays' physical trading often lost money, it nonetheless profited the company overall because its trades helped move the index price that set the value of its larger financial swaps benefiting position. The Commission imposed penalties of $435 million and disgorgement of nearly $35 million. The Commission's Barclays order is currently under review in Federal district court, so that matter is still ongoing. Another topic the Subcommittee has asked about is whether a financial holding company investment with physical energy production has affected how those financial institutions approach the power plant business. The Commission has not taken any view on the participation in its regulated markets by financial holding companies versus more traditional energy companies like generators or utilities. However, that said, the Commission expects financial institutions, like all other participants in FERC-regulated markets, to have good compliance programs, to transact in a manner that follows market rules in letter and spirit, to work cooperatively with grid operators and the Commission when there are concerns, and to self-report potential violations. Everyone has to play by the rules, and encouraging a culture of compliance is the goal of our Office of Enforcement. It is my hope that the description of the work of the Office of Enforcement I have provided demonstrates that the Commission takes very seriously its duty to police the energy markets and protect consumers. To the extent we have succeeded in our mission, it is due to the many talented, dedicated, and hardworking staff at the Commission, and it is my honor and privilege to work with them, particularly the staff in the Office of Enforcement. In conclusion, I want to thank the Subcommittee for the invitation to testify today, and I look forward to answering your questions. Senator Levin. Thank you very much, Mr. Gasteiger. Mr. Tarullo, let me start with you with a general question at the heart of the issue that we have been going at here during this 2-year investigation and this 2-day hearing. The heart of it is an American tradition, the separation of banking from commerce. Not every country takes the approach, but it has been central to U.S. banking law and practice since our country got started. What is your view of the principle? Do you think it is important? And why? Mr. Tarullo. Well, Senator, as you say, separation of banking and commerce certainly since the New Deal reforms has been a centerpiece of U.S. financial regulation and prudential regulation. And I think traditionally it is thought to have served three purposes: First is trying to protect the depository institutions and, thus, the Deposit Insurance Fund and more generally our payment systems from the risks that can be associated with non- financial activities, with commercial activities, which for obvious reasons will not be in the wheelhouse of people whose business is making loans and taking deposits. The second reason for the separation of banking and commerce traditionally has been a concern that, to the degree certainly that insured depository institutions were to be involved directly or indirectly, there will be some form of subsidization of those activities because of the fact that the Federal Government provides an insurance service that is not available in the private sector. A third and closely related reason is a sense that it would be unfair to those operating in the commercial sphere, the non- financial sphere, to have to compete with institutions that did have some form of subsidized funding. And so, as you know, Mr. Chairman, there is a long line of cases, both under Section 24- 7 of Title XII of the National Banking Act and also under the Bank Holding Company Act, trying to draw the line between finance and commerce, banking and commerce more generally. But I would say that nothing that I have observed in my time teaching in this area, writing in this area, and in the almost 6 years on the Fed has changed my view that fundamentally this has been a sound principle and there is no particular reason to digress from it. Now, having said that, as you well know, and as many have pointed out, in 1999 the Gramm-Leach-Bliley Act poked some fairly big holes in that traditional separation, and so part of the ongoing issue, which I think is probably raised in your Report, is how in the absence of additional legislation one can, in a manner consistent with the statute, confine the risks of all three sorts that I was just mentioning a moment ago. Senator Levin. In 2009, in response to the financial crisis, the Fed revamped its organizational structure, created the Large Institution Supervision Coordinating Committee, whose operating committee created, in turn, a Risk Secretariat, and the mission of that Risk Secretariat was to identify key risks affecting systemically important financial institutions and also to provide the resources needed to conduct in-depth risk investigations. And in one of its first actions, it identified bank involvement with physical commodities as an emerging area of risk that required review, and it set up and funded a multiyear review effort by a Federal Reserve Bank of New York Commodities Team that dug deep into the facts, producing multiple examination reports. And then in October 2012, 2 years ago now, it issued a summary report with a number of recommendations. Can you summarize the risks that were uncovered by that special review? Mr. Tarullo. Well, I am going to mediate that somewhat, Senator, because I am going to summarize what was told to me in going through that review. And I might say that I cannot remember exactly when the date is, but it was on one of the trips I made to New York when I was using the New York Fed as a base to do some meetings that some of the people on the New York Fed Examination Team asked to meet with me because they wanted to present some of the concerns that they had. A lot of those concerns revolved around the potential for catastrophic risk, which we mentioned in the ANPR and to which I alluded in my prepared remarks. I think there is a sense--usually when you think about an investment or a loan, any sort of asset, whether it is a loan or a tradable security or even a piece of property, you tend to think in terms of the potential for loss being at maximum 100 percent of the value of that asset. So if it is a loan, your counterparty defaults, you do not get anything back. If it is a security, a company goes bankrupt, you do not get anything back. But in the case of some forms of commodity activities, because of the potential for very large tort exposure, the potential--or tort-like exposure, the potential losses to a firm could far exceed the value of that asset. And I think that was at the core of a lot of what the concerns of the people who are looking at the potential risks were. Again, as I mentioned in my introductory remarks, the big changes in 2008 whereby a lot of activities were imported into bank holding companies, either by the conversion of the IB into a bank holding company or by the acquisition of the investment bank, brought in a lot of things that were not traditionally in bank holding companies for the reasons that you were mentioning in your first question. I came with that as the core of concerns, and it is not the only thing that we are concerned with, but it has animated our concerns ever since. Senator Levin. Now, what our research indicates is that overall, with few exceptions over the years, and setting aside the issue of gold and silver, banks and their holding companies were not very involved with commodities until the 1970's when commodity markets for the first time started to get into non- agricultural commodities. When it was grain and pork bellies, the banks were not very interested. When the commodities markets got into crude oil and natural gas futures, that is when the banks became interested and active in physical commodities markets. Is that generally in keeping with your understanding? Mr. Tarullo. That is in keeping with my understanding. The oil crisis and its aftermath did seem to work a big change in how people generally thought about commodities trading. Senator Levin. And you have made reference to the enactment in 1999 of Gramm-Leach-Bliley. Would you agree that what it did in creating a category of financial holding companies and authorizing them to get into a wider array of activities led to a surge in financial holding company involvement with physical activities--physical commodities? Mr. Tarullo. Sure. So I think it proceeded in a couple of steps, Senator. One was just the authorization. Then, of course, there was the bankruptcy of Enron, which left a void, which some of the institutions thought they could begin to fill. And so you did then begin to see more movement into trading activities with those complementary determinations that I referred to in my prepared remarks. But I think the next piece of what cumulatively was a surge was the change from the status of the freestanding investment banks, which brought a lot of non-trading activities under the umbrella of bank holding companies. So I would say cumulatively it was a surge. It proceeded in a few somewhat distinguishable steps. Senator Levin. One of the key issues that has been raised in the physical commodities area involves unfair trading and market manipulation. In 2005, when JPMorgan filed an application with the Federal Reserve requesting complementary authority, JPMorgan explained that engaging in physical commodity activities would do the following, and these are their words: It would position JPMorgan Chase in the supply end of the commodities market, which in turn will provide access to information regarding the full array of actual producer and end-user activity in those markets. The information gathered through this increased market participation will help improve projections of forward and financial activity, and these are the words that strike me as being so prescient, important, and disturbing--it will supply vital price and risk management information that JPM Chase can use to improve its financial commodities derivative offerings. So they are going to gain information here that is not public information. They are going to gain information that they can use to improve its financial commodities derivative offering. Access to information will help its trading operations, and, again, that is not public information. And here is how a 2005 article described Morgan Stanley's physical commodity activities in comments by one of its leaders, a man named John Shapiro: ``Having access to barges and storage tanks and pipelines gives the bank additional options to move or store commodities that most energy traders do not pursue. And by having its finger on the pulse of the business, it hopes to get a more subtle feel for the market, a crucial asset to a trader. Being in the physical business tells us when markets are oversupplied or undersupplied.'' ``We are right there, seeing terminals filling up and emptying.'' So, again, it is the trading value. It is a crucial asset to the trader if they are in these businesses at the same time. And here is what some Federal Reserve examiners noted when they were analyzing physical commodity activities by Morgan Stanley and Goldman: ``The relationship of the firms''--Morgan Stanley and Goldman--``with the wholly and partially owned companies is not that of a passive investor. In addition to the financial return, these direct investments provide the firms with important asymmetrical information on conditions in the physical markets such as production and supply demand information, etc., which a market participant without physical global infrastructure would not necessarily be privy to.'' Interesting word, ``asymmetrical'' information. I am the Chairman of the Armed Services Committee, and we hear that word ``asymmetrical'' all the time. In a way there are some similarities, by the way. Finally, we have an excerpt from an October 28, 2011, presentation by the Goldman Commodities Division to the Goldman Board of Directors, and this is what it says: ``Goldman Sachs may command valuation multiples for Goldman Sachs commodities similar to Glencore if the business were able to grow physical activities''--and here are the key words--``unconstrained by regulation and integrated with the financial activities.'' That is Goldman Sachs' words, which they repeated yesterday. I asked about that. Do you believe that physical activities and financial activities should be integrated? What happened to that Chinese wall you guys claim between information that you gain in the commodities world and your work in the financial world? Now, my concern with all of these statements is that financial holding companies want access to physical commodity activities primarily so that they obtain access to commercially valuable non-public information that they can use when trading financial instruments relating to the same commodities--non- public information relating to those commodities gained by these financial firms, which they can then use in the trading of financial instruments that are related to those commodities. Now, that to me introduces unfair trading advantages, market manipulation issues into our commodity markets. Yesterday we explored how Goldman's wholly owned warehouse company, Metro, contracted with metal owners in its warehouse system to artificially inflate a queue, a line of people, who are waiting to leave its warehouse and inflate prices of aluminum and aluminum-related financial products. That is what happens. The premium for aluminum is directly connected to a long line to get out of a London Metal Exchange-approved warehouse. The longer the line, the greater the rent is paid in that warehouse. That rent is part of a premium, and so the portion of a cost of aluminum now that is reflected in the premium is now up to over 20 percent. It was 5 percent a few years ago. And so you have a major financial institution, Goldman, that directly is involved in a decision to lengthen a line, which in turn increases the premium, which is a growing and growing part of an aluminum price, and their decision to lengthen those lines with that effect is not public, the decision, and they are trading in commodities, including futures, which are obviously impacted by that non-public information, which they can then apparently use. Now, the Fed provides certain attractions to financial institutions. There are certain advantages that they have. When banks are involved in commercial institutions, like power plants, storage facilities, coal mining, and aluminum warehouses, the Federal Reserve is the source of competitive advantages. You provide advantages. Doesn't the Fed have some responsibility to ensure that banks do not use those competitive advantages to engage in market manipulation? I know other regulatory agencies have responsibilities here. Doesn't the Fed that provides these advantages to companies have some responsibility to make sure that those companies, which have these unique advantages, are not engaged in manipulative activities? Mr. Tarullo. So I would say first, Senator, that a lot of the Dodd-Frank Act and associated reforms that we are doing, along with other regulatory agencies, are actually designed to make sure that holding companies do not have an advantage and that the costs of the risks that they may impose on the financial system are fully internalized in their own costs of doing business. I have not had a chance to read the entire Report, but I did take the summary and recommendations on the train with me the other day, and I was struck by the fact that so many of the case studies which you and your staff have investigated so thoroughly seem to revolve around the co-activities of trading and what I think you usefully described as ``infrastructure,'' owning extraction facilities, transportation facilities, and the like. That seems to create the biggest potential for the kinds of activities that you have been referring to, and there I would say, first, the interpretation of complementary authority, which, as you know, we are revisiting in any case, but even under the existing determinations, they explicitly exclude what you would describe as the infrastructure. So under that authority, there should be no possibility of doing that. Under merchant banking authority, it would be my premise that the notions of separation of the portfolio investments by merchant banking operations from the operations of the bank should also in turn mean that there is no commingling of managerial and other kinds of information. So that basically leaves us with subsection (o), the grandfathered authority, and any residual transitional authority that firms may have to maintain noncompliant activities during a divestiture period. So with divestiture periods running, with the Fed's complementary authority excluding such possibility, and with some of the other changes that I have been mentioning, I think it does come back to this issue of whether 4(o) continues to permit exactly the kind of structural circumstance that you are concerned with. In terms of our oversight, I think I spoke to this in a speech rather than testimony not too long ago. The accumulation of violations--investigations and in many cases, I think, acknowledgment of violations in a variety of non-prudential regulatory areas, whether it is LIBOR or forex price fixing or mortgages, and some of the things you have raised in commodities, the work that FERC did on JPMorgan, suggests that, in general, the compliance procedures, mechanisms, expectations within firms for abiding by laws, which may not be prudential from us, but they are nonetheless from our sibling regulatory agencies, are not adequate in many cases. And so one of the things that we have been thinking about in general, although now specifically in the commodities context as well, is how to assure that there are robust enforcement and compliance mechanisms within firms to make sure that you do not have this kind of transgression of other regulatory areas. The final thing I would say on this is, I am not an expert in commodities law, but, again, as I read the summary of what you had produced, I began to wonder whether there is a gap in regulation more generally, whether there are some things, such as some of the things you describe in some of these case studies, that at present no U.S. Government regulatory agency has jurisdiction over. I do not know if that is true, but it felt to me as though it may be true in a couple of cases where there is something that neither the CFTC--it is not energy; it is not going to be FERC--nor the SEC is actually able to regulate because something is not a future, for example. So it could be that you have also uncovered a third agenda, which is addressing some of those gaps, whether or not it is bank holding companies. Senator Levin. Well, one of our recommendations I think fits very closely to what you have just been talking about. This is a bipartisan recommendation, No. 8 of our Report: Financial regulators should ensure that large traders, including financial holding companies, are legally precluded from using material non-public information gained from physical commodities activities to benefit their trading activities in financial markets. Now, I think that fits very closely with what you just said. Mr. Tarullo. I think it does, Senator. Senator Levin. And Recommendation No. 11 would be or is that the Office of Financial Research should study and produce recommendations on the broader issue of how to detect, prevent, and take enforcement action against all entities that use physical commodities or related businesses to manipulate commodity prices in the physical and financial markets. Will you take a look also at that recommendation and give us a reaction to that, if you would? Mr. Tarullo. Sure, absolutely. Senator Levin. Because as you have just pointed out, it just seems like every day there is another example of market manipulation, and you mentioned, I believe, interest rates and foreign exchange rates and energy prices. Now you can add aluminum. And these too-big-to-fail banks that have access to the Fed's discount window and near-zero borrowing costs are engaging in the manipulation of numerous markets, and each one of these falls under the oversight of a different regulator, technically. But you are the only constant regulator we have, the Federal Reserve, and your willingness to get in to make sure that regulations are abided by, even if those regulations are regulations of your, as you put it, sibling agencies, could be a very important step, because if banks do not do that, then their safety and their soundness could be impacted if either there is no regulation, which may be the case, as you have just referred to, or if the regulations of other agencies either have gaps or are not lived up to. So that commitment on your part to look at this and to think about that possibility is very important. We have a situation which is totally unacceptable to me, and that is that in the area of commodities, which do not have the same regulation as stock, and are not subject to the same rules about inside information, for instance, as is true in the stock market, with the SEC looking at misuse of inside information, that does not exist in the same way, at least, in the commodities area. The information used in the commodities area was not regulated because that information started a hundred years ago with a farmer trying to calculate how big a crop he was going to have. That world is totally upside down now. Now 70 percent of the transactions are speculative. They are not by the end users. It used to be 70 percent of the transactions and future contracts were by people who actually were going to use something. Now it is 30 percent. So the speculators have taken over, which is their right, but it is also our right as a government to make sure that information which they gain is not misused, just the way we take steps to make sure inside information is not misused. And it is very important that the Fed become much more aggressive and interested in making sure that the possibilities here do not become real and that the real abuses are not accepted so that the safety and soundness of our banks, for instance, is not ultimately at risk, nor is the consumer taken advantage of. Mr. Tarullo. Senator, do you want a quick reaction to that? Senator Levin. Sure. Mr. Tarullo. One of the things that Congress did in the Dodd-Frank Act was to substantially both change and give a message to agencies for further change on interagency cooperation and interagency coordination. The systemic risk and financial stability mandates of the Dodd-Frank Act are already occasioning the kinds of discussions between the market regulators on the one hand and the banking regulators on the other that did not take place very often prior to the financial crisis. We now have a formal interagency group of regulators that can look at gaps in the regulatory structure. So my immediate reaction is that it would be a good idea for the relevant agencies, including the Fed and OCC because of our involvement with banks, but also the market regulators, to take a look at exactly this issue of how regulations are expected to be complied with throughout an organization and whether there are any lacunae in the regulatory structure that might bear a recommendation for action. Senator Levin. I think it was your study which pointed out some numbers as follows, the Fed study: That financial holding companies typically have a capital ratio of 8 to 10 percent, where oil and gas companies, for instance, have capital ratios exceeding 40 percent. The end result of that is that due to cheaper financing costs and lower capital ratios, which I have just mentioned, financial holding companies can nearly always undercut any non-bank competitor. Now, we saw examples of that type of unfair competition in our investigation. Morgan Stanley used shell companies called Wentworth to construct a compressed natural gas plant in direct competition with a company called Emera; and where Emera had proposed building a compressed natural gas plant to export 9,000 billion cubic feet of gas per year, Morgan Stanley proposed a plant to export 60 billion. Senator Levin. I misspoke there. The private company had proposed building a plant to export 9,000 cubic feet of gas; Morgan Stanley proposed a plant to export 60 billion cubic feet. Now, I am guessing that Morgan Stanley had a whole lot more money than Emera to invest and could do it with less capital and less financing costs, and Emera just simply could not compete with that, and I am wondering if that is a concern of yours, Governor Tarullo. Mr. Tarullo. Well, I think what may lie behind some of those capital numbers you cite is, again, the concern about catastrophic risk and potential risks associated with some of these activities. A centerpiece of the analytic work that the Fed staff has been doing over the past year and a half or so has been on precisely that point. And, of course, what that translates into is questions about the appropriate risk weights that should be assigned to certain kinds of activities. So as you know, in Basel III and some of the other changes we have made in capital requirements, part of it has just been upping the ratio; part of it has been saying, wait a second, there are a lot of asset classes that were riskier than existing risk weights would have suggested. So a key part of our review has been precisely around this issue of are risk weights appropriate, reflecting in particular the potential for catastrophic loss. And I expect that that is the kind of work which will come to fruition in the not too distant future. Senator Levin. Mr. Gasteiger, let me turn to you for a few moments, and then we will have a few more questions as well, for Governor Tarullo. You have described in your testimony electricity manipulation cases involving three financial holding companies: Barclays, Deutsche Bank, and JPMorgan. And in each of these cases, very different types of manipulative schemes were employed. Now, one of the messages, I would think, from those cases is that there are lots of ways to abuse the system, and regulators have to police a lot of different aspects of the electricity markets to catch wrongdoing. Would you agree with that? Mr. Gasteiger. Yes, I would, Mr. Chairman. Senator Levin. And where does the manipulation case that FERC brought against JPMorgan stack up in terms of significance and size of manipulation compared to other cases that FERC has brought? Mr. Gasteiger. Mr. Chairman, the JPMorgan case would be the largest settlement to date that the Commission has gotten under its EPAct authority. Senator Levin. And it is my understanding that independent system operators in California and Michigan had never before witnessed the degree of blatant manipulation and gaming strategies that JPMorgan used to try to profit from its power plants. Is that correct? Mr. Gasteiger. I think it is safe to say that the schemes particularly in California were more numerous than anything that I am aware of having seen before. Senator Levin. Is it also true that because of JPMorgan's manipulative bidding strategies, the independent system operators in California and Michigan had to revise the way they allow companies to bid on electricity in California and Michigan? Mr. Gasteiger. Yes, it is true; several tariff filings had to be made to make changes to the markets. Senator Levin. And with regard to the JPMorgan manipulations that resulted in a $410 million settlement, it began with the hiring of one new employee, is that correct, a man named John Bartholomew, who advertised in his resume that he had identified a ``flaw'' in the market mechanism, make- whole payments, that is causing CAISO to--is that the way it is pronounced, CAISO? Mr. Gasteiger. We say CAISO. Senator Levin [continuing]. To misallocate millions of dollars. In other words, he in essence believed that you could profit by gaming the system rather than from selling electricity at market rates, and in a matter of hours of sending in his resume, the head of JPMorgan's Houston office, Mr. Dunleavy, instructed others to get him in ASAP. Is that what your investigation found? Mr. Gasteiger. Yes, Mr. Chairman, that is correct. Senator Levin. And there are two things that I find incredible about this: The first is that anyone would advertise in a resume that they know about a flaw in the system, signaling that they are ready and willing to exploit that flaw; and, second, that somebody would hire the person sending that signal. The enforcement staff of FERC found that between 2010 and 2012, JPMorgan engaged in 12 types of improper bidding strategies. Is that correct? Mr. Gasteiger. That is correct, Mr. Chairman. Senator Levin. Is it also true that the FERC staff discovered some of these schemes during its investigation and brought them to the attention of JPMorgan and that JPMorgan did not stop the manipulative activity but instead developed new schemes? Mr. Gasteiger. That is correct. Senator Levin. And in one of these manipulative schemes, JPMorgan traders submitted bids that offered to sell electricity at rates well below JPMorgan's cost to generate electricity, which meant that the offers usually lost money when accepted, and JPMorgan was willing to make those artificially low offers, sort of like a loss leader, so that it could then participate in certain ``make-whole'' payment mechanisms that could end up generating payments well in excess of the expected losses. Do I have that right so far? Mr. Gasteiger. Yes, Mr. Chairman. Senator Levin. And those make-whole payments allowed generators to be compensated at above-market electricity prices to provide an incentive for plant owners to participate in the bidding auctions and ensure grid reliability. Is that correct? Mr. Gasteiger. Yes. Senator Levin. And so JPMorgan used its bidding strategies to more than make up for the money it lost at market rates, frequently receiving in the end more than twice its costs because of the make-whole mechanism. Mr. Gasteiger. That is correct. Senator Levin. And in the end, JPMorgan's bidding schemes caused California and Michigan electricity authorities to pay approximately $124 million in excessive payments to JPMorgan. Mr. Gasteiger. That is correct. Senator Levin. Now, we have an exhibit, which is a copy of an email--and we will get you the number of that exhibit in a minute. It is a copy of an email that JPMorgan sent to several colleagues in the midst of abusive bidding schemes. It contains an image of Oliver Twist extending a bowl, and the subject line: ``Please, sir, more BCR.'' Now, the BCR refers to the make-whole payments that JPMorgan was using to unfairly profit from the system. And I got to tell you, it is mighty offensive to me that JPMorgan portrays its actions as a joke, comparing itself to a poor orphan needing charity when it was ripping off consumers. Did that email offend you? Mr. Gasteiger. I agree it is a striking image. Senator Levin. Is it an offensive use? Mr. Gasteiger. I would agree with that characterization. Senator Levin. Now, I understand that in connection with the CAISO and FERC investigations into JPMorgan's manipulative bidding schemes, JPMorgan refused to hand over a number of documents, claiming attorney-client privilege, but it later turned out they were not privileged at all. Can you describe what happened in that regard? And what was the penalty that FERC imposed in a response? Mr. Gasteiger. There were disagreements between us and JPMorgan throughout the course of the investigation over access to documents. Ultimately there was a proceeding--this really actually dealt more with disagreements that JPMorgan was having with the California ISO market monitor with respect to access to information as part of its investigation. In a separate proceeding that was not directly part of the enforcement investigation, the Commission ultimately suspended JPMorgan's market-based rate authority for a period of 6 months. Senator Levin. Now, all three of the financial holding companies that we looked at--JPMorgan, Goldman, and Morgan Stanley--were active in power plant activities, using the Fed's complementary merchant banking or grandfather authority. Did you get a sense, Mr. Gasteiger, that these financial holding companies really want to own or operate electric power plants, or is it more likely that they are in the business for financial gains, for the financial trades end of their business, to get non-public information that can assist them in their trading operations? Mr. Gasteiger. In the limited number of cases that we worked on, particularly JPMorgan, clearly they were using the ownership in order to engage in the type of market activities that we were investigating. And in that particular instance, because the units were not themselves profitable, they were looking for ways to try and do that, that is what led them to develop the schemes that they wound up implementing in CAISO. Senator Levin. And what would be the relationship then to the financial trading end of their businesses? Mr. Gasteiger. Well, because of the ownership of the plants, that led them to engage in those financial trading activities within those markets. Senator Levin. From what you have seen in enforcement cases brought by FERC, the financial holding companies have the same commitment to understanding and following electricity-related regulatory regimes as, say, utility companies that are focused on the electricity business, or are they more prone to try to game the rules? Mr. Gasteiger. Well, Mr. Chairman, we have not undertaken any type of a real study, but on the limited sampling that we have, certainly as you indicated earlier, as my testimony indicates, financial institutions have, in fact, been involved in the most significant cases that the Commission has brought through its enforcement authority. Senator Levin. And would that seem then to fairly imply that they do not have the same commitment from that experience to following the regulatory regimes that are supposed to govern electric utilities as those electric utility companies that are focused on the electricity business have? From that limited experience, is that a fair statement? Mr. Gasteiger. I think one could perhaps draw that conclusion. Senator Levin. Now, FERC has been active in going after manipulation in the electricity markets, and we have not seen the same level of activity in other markets, such as for crude oil, aluminum, or copper. Now, part of that is that no Federal regulatory agency has been assigned explicitly the responsibility to prevent price manipulation in the same way as FERC, especially in the purely physical markets. But it seems to me that FERC's experience in uncovering manipulative schemes as well as other enforcement cases that we have seen suggests that too many Wall Street financial holding companies are ready and willing to engage in market manipulations and will do so until they are caught. Governor, does the Federal Reserve have authority to bring a market manipulation case? Or is that basically for other agencies? Mr. Tarullo. Market manipulation as such would not be within our ambit, Senator, although when one of the other regulators with authority is able to bring an enforcement action, we are often able to cooperate with them to require certain remediation measures in compliance within the firm and, where appropriate, to impose penalties on the firm for violation of safety and soundness and other compliance activities. Senator Levin. And if other agencies do not bring enforcement action where there is clear evidence that enforcement action is appropriate, are you in a position, as someone having overall responsibility, to talk to other agencies about why enforcement actions against manipulation are not taken? Mr. Tarullo. Yes, that is right. There are two distinct issues. One is if we uncover activity which is arguably--it does not even have to be definitely, but arguably a violation of law or the regulations of a sibling agency, we absolutely will initiate contacts with them. If it is a circumstance in which nobody has--people conclude that nobody has authority, then it is a somewhat different situation and one that I was alluding to earlier where it may be that there need to be some recommendations to Congress as to how to fill in some of those gaps. Senator Levin. We would ask you, Governor, to take a look at our recommendations. I do not think we want banks that are under your authority and have advantages because of their connection to the Fed to engage in manipulative activities. I do not think that you want it. I do not think anybody should want it. And if there are gaps--and there are--in the way manipulative activities are taken out or stopped because there is an absence of regulation or a failure of regulation, we believe it is essential that those gaps be filled. We cannot tolerate what we saw with the Goldman warehouses in Detroit, for instance. It is totally intolerable. And so if you would take a look at our recommendations in the Report and tell us--not now but for the record--in addition to what you have just told us, what the Fed might do to help go after the manipulation in these banks that have advantages from the Fed, we would appreciate it. Mr. Tarullo. Of course. Senator Levin. Now, one of the most significant things that we saw, Governor, in our Report and investigation is that there is no overall size limit on the amount of physical commodity activities for banks and their holding companies. For instance, JPMorgan used loopholes, exclusions, and valuation techniques to stay under the Fed's limit. And as a result, in September 2012, JPMorgan had physical commodity holdings of $17.4 billion, which was equal to 12 percent of its Tier 1 capital, at the same time it told the Fed that it had $6.6 billion, or 4.5 percent of its Tier 1 capital. The discrepancy between those two numbers is stark, and it shows just how ineffective the current limits are. Physical commodities, as you know by heart, may be held under complementary authority, in which case they are subject to the 5-percent Tier 1 capital limit; under grandfather authority, in which case they are subject to a limit of 5 percent of total consolidated assets; and under merchant banking authority, they have no limit at all, but they are governed by the other criteria in that authority. None of this counts anything against what is held by the banks under the authority of the OCC. Now, this would look to me like a problem that seems ready for rulemaking. In Section 5(b) of the Bank Holding Company Act, the Federal Reserve has broad authority ``to issue such regulations and orders as may be necessary to enable it to administer and carry out the purposes of this chapter and to prevent evasions thereof.'' And the Federal Reserve has used its broad powers in the past. It previously had a limit on merchant banking activities, which it removed via a rulemaking in 2002. It also imposed the 5-percent complementary authority limit without statutory direction. So the authority would see to be there for the Fed to impose an overarching limit pursuant to its broad authority under the Bank Holding Company Act. Given the significant differences in the risks posed by a 4.5-percent interest in commodities versus a 12-percent interest, do you believe that the Bank Holding Company Act gives the Fed sufficient legal authority should it choose to enact it or use it, do you have the authority, should you choose to enact an overarching limit on the physical commodity holdings of a financial holding company? Mr. Tarullo. Let me put aside subsection (o) for a second, authority under subsection (o). I think with respect to--and I want to give my own current understanding, not having consulted with our Legal Division on this, but I would suspect that we do have authority to put an overall limit, certainly as we already have on complementary, and quite possibly on merchant banking activities as well. With respect to the broader issue, when you have a Section 4(o), my initial reaction would be that we probably would not have authority to bring down below the congressional 5-percent level the amount of activity--and that is 5 percent of assets, too--the amount of activity in a Section 4(o)-eligible firm. But we could certainly say that we would not allow any more than that. So, once again the Section 4(o) provision creates a different circumstance for those two firms really than for anybody else, but more broadly, I think we do have pretty good authority. Senator Levin. Can you get back to us on the question of whether or not you have the authority to put an overall limit that would then be the combination of those sub-limits and those sub-authorities? Mr. Tarullo. Right. Senator Levin. Can you check with your Legal Division and get back to us? Mr. Tarullo. I would be happy to. And as you know, and I think it was in the Report. You probably know it even if it is not in the Report. The difference between 5 percent of capital and 5 percent of assets is huge. Senator Levin. And would you also let us know for the record whether or not the Fed believes that the Bank Holding Company Act provides sufficient authority to place a reasonable size limit on a financial holding company's physical commodity activities overall to limit the commingling of banking and commerce? Mr. Tarullo. Sure, we can do that, too. Senator Levin. In 1997, the Federal Reserve issued a regulation which said in part that bank holding companies can treat copper as bullion, treating it the same way as gold and silver. But for more than 100 years, commodity markets throughout the world have treated copper as a base metal, not a precious metal, valued for its uses in industry rather than as a medium of exchange like gold or silver. The only thing that changed was its regulatory status. Designating copper as bullion has made it exempt from size limits that would otherwise apply and from reports that are required of financial holding companies to be made to the Federal Reserve about the dollar value of their physical commodity holdings. At the same time, our investigation has shown that JPMorgan and Goldman engage in massive copper transactions and actively build and reduce their massive copper inventories, which at JPMorgan peaked at $2.7 billion and at Goldman reached $2.3 billion. Now, what is the rationale for exempting copper from size limits and commodity holding reporting requirements? How is it risk-free? Mr. Tarullo. Well, Senator, that was an interesting decision, and my understanding--because I asked about it, because that was long before I got to the Fed, and what I was basically told was it followed on an OCC decision that made a similar determination for holdings of copper within national banks, and so what it appears to me as is the Fed proceeded to say, if they are going to be doing this stuff, we do not want to force it into the banks, so permit it in the holding company more generally. Having said that, I think I cannot offer, again, a Board position on this, but I just would observe that I think a pretty good case could be made for the proposition that copper is different from palladium and copper does seem to be basically an industrial metal. And so it is something that would bear revisiting, I think. Senator Levin. Will you talk to the OCC about the possibilities of making a change in that regard? Mr. Tarullo. I will. Senator Levin. Really, there is huge risk with this kind of ownership and inventory at billions and billions of dollars, particularly since it has no business in that category. So if you will talk to the OCC, we would appreciate it. Will you do that? Mr. Tarullo. Sure. Senator Levin. Now, in 1997, that is covered. A question about merchant banking. Gramm-Leach-Bliley indicated that it intended to allow merchant banking investments only if they were financial in nature. That is where the bank acts as a passive investor, does not try to run the company it buys, and holds it for resale to make money off the equity investment. And I think you have talked about that this morning. That is its purpose. From what we have seen, it looks like some of these big banks are not always following the rules. First, there is a lack of information. The merchant banking reports that the Fed gets now and makes public has such high level aggregate data that they are ineffective as an oversight tool. They do not even contain a list of the merchant banking investments at a bank, so it is nearly impossible to tell if all the merchant banking investments are included. So I have two questions. How can a regulator police an activity without that kind of basic information? Let me start with that one. Mr. Tarullo. You cannot do it as it should be done, and I think, Senator, that is one of the reasons why the reporting issue, again, has been another principal topic of internal discussion about the kind of changes we may make. Senator Levin. And it is not enough that the additional information about these activities just be required. It has got to also be made public. Mr. Tarullo. As with all reporting, in any changes we make, we will look to see what the maximum transparency we can provide without encroaching on genuinely business proprietary information. Senator Levin. That would be helpful. Another issue is the issue of whether financial holding companies are getting involved in the routine management of the companies that they buy. We saw Goldman designate its commodities arm, J. Aron & Company, as the exclusive marketing agent for its coal mines, selling 100 percent of the coal on a day-to-day basis. It also appears Goldman was approving coal mining plans and key infrastructure investments. Goldman's ownership of its warehouse company, Metro, raises similar concerns. So they are exercising a whole lot of management control over Metro, as we saw yesterday, and Metro's board is composed exclusively of Goldman's employees, and they were approving freight incentives and this merry-go-round shenanigans and policies related to queue length. So that is a second set of issues. How do you get at that issue as to whether or not they are getting too deeply involved in the day-to-day management of the companies that they buy, which is inconsistent with the rules of merchant banking? Mr. Tarullo. So I think probably two things, Senator. One is compliance with current rules and guidance, which is part of this overall issue I was referring to earlier. And second is the question as to whether we should revisit the actual rules and guidance that have been put out. I do not want to get too biographical here or autobiographical here, but as you know, I was teaching law, teaching banking regulation after Gramm- Leach-Bliley came out. And as you know from law school, the way you teach these things is you give the kids a hypothetical and you say, ``OK, where is the line here? And how do you draw the line?'' And, not surprisingly, good law students can make the arguments on both sides, which suggested to me at the time, and I think I have been reminded of this by some of the work that your Subcommittee has done, that it may be worthwhile taking a look at those merchant banking guidelines, not just for commodities but for all activities, actually. Senator Levin. We are going to ask you and the Fed to take a look at the activities of Goldman and the others that we have in our Report, in this merchant banking area. And I cannot speak for Senator McCain yet because I have not talked to him about this, but I will ask him if he would like to join in a letter to you specifically on this issue, which is on top of the recommendations which are in our Report. Mr. Tarullo. OK. Senator Levin. The third set of concerns involves enforcement. JPMorgan claims to be holding three power plants as merchant banking investments, but only after striking out efforts to hold them as complementary activities. So first it was supposed to be a complementary activity. Then they shifted over to merchant banking as the justification and the rationalization for the authority. Documents from the Fed indicate that JPMorgan promised in 2011 to sell all three power plants. Three years later, JPMorgan still has all three. So, first question, what is your view of how banks have been using the merchant banking authority with respect to physical commodities? Second, what plans, if any, does the Fed have with respect to the problems of inadequate information, bank involvement with routine management, bank failure to sell merchant banking assets, after promising to do so? Mr. Tarullo. That, I think, gets at two of the issues that you have raised. It sort of combines two things you have already raised, Senator. One is the information and reporting, and second is the set of expectations around merchant banking and the understanding and compliance with the understanding of what it means to have a passive investment. As you know, there can be legitimate questions with what is a passive investment when one is talking about a major action that affects the whole value of the investment. But when you are talking about information flows back and forth on a routine basis, that does not seem to go to the heart of the protection of an investment for its own sake, which is supposed to be held as sort of a profit-making proposition over time. Senator Levin. Finally, Goldman has not allocated any capital to cover potential losses from a catastrophic event. Their argument is that it does not have capital allocated to these physical commodity activities of theirs because it cannot be held liable. Goldman says its policies and procedures are adequate and that it will always follow them and that no court anywhere in the world would find otherwise. Earlier today, we had a catastrophic loss expert express grave concerns over their assumptions. Should Goldman be allocating capital to cover potential losses from a catastrophic event? Mr. Tarullo. Actually, Senator, we will look with interest at that testimony that you heard this morning, but, again, as I mentioned earlier, that issue of the potential exposure is really quite central to what we are doing now. And to be honest, that is one of the things that has occasioned the most analysis and continues to occasion the analysis. And I know the Board of Governors, will want some good answers on that as we proceed to think about exactly what is going to be in the Notice of Proposed Rulemaking next spring. Senator Levin. Will you take a look then at the testimony of Goldman in that regard in this hearing yesterday? Mr. Tarullo. Sure. Senator Levin. Because it goes right to what you call a central issue. Gentlemen, we thank you for your service, for your regulatory work, for your appearance here today. We have some idea as to what your schedules are, and your appearance, your cooperation with the Subcommittee is very much appreciated. So go get them. Mr. Tarullo. Thank you, Mr. Chairman. And, again, congratulations. Senator Levin. Thank you. [Whereupon, at 12:21 p.m., the Subcommittee was adjourned.] A P P E N D I X [GRAPHIC] [TIFF OMITTED]