Members of the U.S. Senate got into a bit of a tussle with Goldman Sachs (NYSE:GS) recently over a strange new business the bank is involved in and stubbornly holding onto.
What's the bank up to? Owning and operating aluminum warehouses.
In a nutshell, Goldman realized that by owning a major aluminum storage company, it could influence the actual price of aluminum -- and thus make a lot of money from trading aluminum. Think of it as the next step in the evolution of enhanced trading revenues, though many people, including members of Congress, would argue that it's anything but kosher.
More than that, these types of activities could actually cause some serious harm to the American economy.
So what happened?
Because of the vagaries of the aluminum market, storage is a small but critical component of the metal's price. So by delaying delivery of aluminum to industrial buyers, Goldman was able to bring up the price and capture a bit more revenue -- not only as the owner of an aluminum warehousing firm, but also as a trader on the commodities markets.
On a per-aluminum can basis, the effects were pretty small. The New York Times reports that Goldman added only about one-tenth of a cent to the price of an aluminum can. It's an insignificant amount -- until you consider that Americans use 90 billion cans per year.
Altogether, Goldman, Morgan Stanley, and JPMorgan Chase all had their fingers in similarly questionable deals in copper, coal, uranium, natural gas, oil, jet fuel, and energy (Goldman is the only bank resisting a reduction in its positions).
The problem for financial markets
It's the kind of story that might make you roll your eyes -- those silly bankers at it again, scaring up profits in weird and not altogether comfortable ways -- but it's actually a much bigger deal than a bit of extra revenue.
Not only do these kinds of activities have a real effect on consumers (e.g., rigged electricity brought to you by JPMorgan), but they also present new risks to the banking industry, which, for those keeping score at home, isn't exactly well versed in the ownership and delivery of industrial goods.
That's because carrying huge positions in volatile commodities presents a certain amount of risk -- of course it's better, you could argue, if you control a significant chunk of the market, but you're still talking about big trades in a largely unregulated space.
Because what if an accident occurs in that Colombian coal mine that Goldman controls? What if JPMorgan experienced a catastrophic failure at a power plant?
Well, you might think, in that case the company has capital coverage, right? This is where I would write "ha-ha" if it were appropriate. The Federal Reserve estimated back in 2012 that the capital shortfall from the banks' commodities activities was about $1 billion to $15 billion each, were an "extreme loss scenario" to arise.
To put this in another perspective, consider this: Your average oil and gas corporation has a 42% capital ratio to mitigate risk, meaning that for every $100 tied up in an investment, it holds $42 in capital to cover potential losses.
These bank-controlled companies had an average of $8 to $10 in capital for every $100 tied up.
But it's the economic impact that will get us in the end
The banks' strategies also bode poorly for long-term sustainability, which to me is the most worrying risk of all.
Banks aren't concerned about building a sustainable aluminum market for American manufacturers and soda drinkers, or a reliable and affordable power grid for consumers and businesses. They're concerned about making money, preferably today.
So how are they supposed to make the kinds of long-term investments in infrastructure, exploration, manufacturing, and storage that would benefit both the economy and Americans over the decades to come?
It's simple: To my mind, they won't. And as you can already see, the unfortunate reality is that we'll all be paying the price of it.