Thursday, July 18, 2013 - Those FERCing Energy Traders

Those FERCing Energy Traders

by Sinclair Noe

DOW + 78 = 15,548
SPX + 8 = 1689
NAS + 1 = 3611
10 YR YLD + .04 = 2.53%
OIL + 1.74 = 108.22
GOLD + 8.40 = 1284.00
SILV + .09 = 19.48

Record high closes for the the Dow & the S&P, along with record intra-day highs.

I know you're all wondering why we called this meeting; well, I'd like to report that the company is doing all right, we're managing to scrape by; but we'd be doing a lot better if the staff in the home office would get off their lazy butts and get some work done for a change.

Sounds a bit harsh, doesn't it?

Yet that is how Ben Bernanke started his testimony before the House of Representatives yesterday. Actually, what he said was: "The economic recovery has continued at a moderate pace in recent quarters despite the strong headwinds created by federal fiscal policy."

Bernanke has a point. Whatever motivation you assign to monetary policy, there are limits to the potential benefits, and those benefits are primarily limited to banks. Accommodative monetary policy is slow to flow to Main Street.

Wall Street has been very happy with QE, as we discussed yesterday. The bankers and hedge funds, and the shadow banks feel the future is assured as long as the economy remains weak and the Fed continues cash infusions into the banking system, and therefore most investments will succeed. In that kind of environment, the income earning ability of an asset is secondary to the capital gains potential. The Wall Street crowd pays higher and higher prices for assets and they finance their purchases with ever rising mountains of debt building up on the Fed's balance sheet. If you want to see the direction of the stock market, just look at a chart of the Fed's balance sheet.

Sure enough, Bernanke says he'll continue with easy money and the market hits another record today; just like clockwork. And that's all fine until some trader somewhere makes a bad mistake, and then everything freezes, and liquidity turns to block hard ice. Bernanke, as a student of the Great Depression, probably doesn't want to see that happen. And so on his Farewell Tour of Congress, Bernanke has pushed for fiscal policy to bridge the disconnect between the markets and Main Street.

Today Bernanke appeared before the Senate Finance Committee and the prepared remarks were the same as yesterday's and I haven't seen much of anything in the question and answer session to raise a flag: the future of monetary stimulus will be tied to the health of the economy, nothing is changing, and by the time it does change, Benny will be retired. Thank you and goodnight Mrs. Calabash, wherever you are.

Let's all jump in the Way Back Machine. You may remember that back in the 1990s, the US began deregulating electricity markets. States like California, New York, and Texas reorganized their “markets” to facilitate wholesale buying and selling, in other words, trading of electricity. You remember all that talk about free markets and such.

Now, let's set the Way Back Machine to the Summer of 2000; a typically warm California summer had people cranking up the AC, and Enron was cranking up the manipulation. Back in 2000, the Golden State had installed generating capacity of 45 gigawatts, and when everybody turned on the AC, the demand reached 28 gigawatts; energy traders took power plants offline for maintenance during peak demand. The result was rolling blackouts and power selling at a premium price, sometimes up to a factor of 20 times normal value.

Fast forward to March 2013; the Federal Energy Regulatory Commission, or FERC, alerted JPMorgan that it would recommend penalties against its power-trading unit. The notice said JPMorgan devised "manipulative schemes" that transformed "money-losing power plants into powerful profit centers." The alleged foul play stems from the bank's 2008 takeover of Bear Stearns, which was then at death's door due to its risky investments in the mortgage market. Turns out that Bear Stearns also had interests in out-of-date power plants, which JPMorgan acquired as part of the takeover.

Feeeling pressure to generate profits, the JPMorgan traders devised a scheme to take advantage of something called a “make whole” provision in energy markets. First, traders would offer a low bid to deliver a minimum amount of electricity from a plant the next day, ensuring that the plant would be turned on. And then the next day, traders would offer a much higher bid for the plant's electricity, virtually guaranteeing that no one would buy. The plant would thus operate well below capacity, and lose money.

But they didn't lose money because the make-whole provision requires plants to be repaid if their profits don't make up for the costs of getting the plant up and running. JPMorgan allegedly took advantage of that fact to squeeze money out of the states and make a profit. So they were trading solely to influence the price and not based upon normal supply and demand fundamentals.

On top of the allegations, investigators are accusing JPMorgan of systematically covering up documents that revealed the alleged trading strategy, including one that showed Blythe Masters, the global head of commodities for JPMorgan, demanding a "rewrite" of a document that questioned whether the bank was acting legally. FERC is also claiming that Masters gave "false and misleading statements" about trading practices under oath.

Well, now it appears that FERC and JPMorgan are on the verge of a $500 million settlement. Earlier this week FERC ordered Barclays to pay a $470 million penalty for suspected manipulation of energy markets in California and other Western states. Barclay's is fighting the charges.

You may be wondering what JPMorgan, or Bear Stearns, or Barclays were they doing in the energy business? JP Morgan is a major player in all facets of the energy markets, not only electricity, but also oil, oil storage, petroleum derivatives such as gasoline and heating oil, diesel and more. They don't produce electricity or oil or gas; they trade these commodities. The big banks are players of particular significance, with virtual limitless funding available to them as 'banks' at the Fed window. They then trade, or gamble, or manipulate energy prices in the field of oil and gas and electricity; and their trading has an important bearing on the formation of prices of these commodities. If their actions in the electricity markets are an example of how they play the game, then one could well surmise that it is not only utility customers that are paying manipulated prices for their energy needs.

So, you can see that JPMorgan might be keen to settle this FERC accusation and move on. For you and me, $500 million sounds like a lot of money, but it's not like it would come out of Jamie Dimon's wallet; it's a write-down and the accountants will deduct it from taxes; and it's less than 7% of the losses attributed to the London Whale; and you recall that was, according to Dimon, nothing more than a “tempest in a teapot.”

Which means that the overall deterrent value of the FERC settlement is zero, and it's just a matter of time until the next Enron, or Barclays, or JPMorgan manipulates the energy markets in a way that is deemed egregious and illegal. Meanwhile, they continue to legally trade in the energy markets casino.

Just look at the earnings results from the most recent reports: Goldman’s quarterly profits doubled, with debt underwriting up 40% to a record, and fixed income currency and commodities (trading) up 12%. Bank of America’s Q2 profit rose 63% based on “global markets” fixed income, currency, commodities, and equity trading up a reported 93%. Citicorp’s Q2 profits were up 42%, with profits up 63% from trading stuff. And JPMorgan’s profits in the quarter rose 31%, with a 38% rise in investment banking fees, a 19% rise to $2.8 billion from investment and corporate banking, a 50% rise in debt underwriting and an 83% increase in equity business line.

So you know, nobody really knows how things like investment banking “fees” are calculated, or debt underwriting, or whether or not they include “market-making,” otherwise known a “trading,” that happens on the other side of underwriting and investment banking deals. And in America, no banker goes to jail because we believe in free markets. So everything is good because they're trading, and they're making money. Where does that money come from? You know the answer.