By Lauren Tara LaCapra and Michael Erman
NEW YORK, Aug 6 (Reuters) - Morgan Stanley is exploring various options for its multibillion dollar commodities business, with the sale of a minority stake being one possibility, three sources familiar with the situation said on Monday.
The business, which includes three U.S. power plants, a 49 percent stake in a tanker fleet and a pipeline and logistics firm, has been shopped for more than a year. But the bank is not in any hurry to sell a stake at any price and is not close to a deal, the sources said.
Morgan Stanley has been vague about what it plans to do with the business, though executives have said that all options are on the table. The sources said the bank is not being pressed to sell the entire business, despite increasing scrutiny of Wall Street’s commodity trade in Washington.
Still, it has also been more blunt than its rivals Goldman Sachs and JPMorgan Chase & Co about the pressures on the business - both in terms of rising capital requirements and falling trading margins - as well the regulatory question marks over its commercial activities beyond derivatives.
The most critical regulatory decision rests with the Federal Reserve, which by September is expected to decide how much latitude to grant Morgan Stanley and Goldman Sachs to invest and trade in physical commodity markets such as metals warehouses and tankers.
September marks the end of a five-year grace period to comply with commercial banking regulations after the two gave up their independence at the height of the financial crisis.
It is not clear how much, if any, of its commodities operations the Fed may force Morgan Stanley to sell. That deadline comes at a time when the banks are also being pressured to restrict their risk taking as a result of the Dodd-Frank financial reform law.
“Under Dodd-Frank, the ability to continue to acquire real assets and trade around those real assets is restricted for us and for the industry. We’ve had a very difficult cyclical period, in full candor, in the last six months,” Chief Executive James Gorman said in June.
The sources said they don’t believe the bank will be forced by regulators to sell the business. The Federal Reserve has declined to comment on its deliberations.
Gorman detailed plans to double or even triple returns in other businesses by shedding assets and increasing market share, but did not give a forecast for returns in commodities trading. That business has a return on equity below 5 percent - less than half of what it needs to meet its cost of capital.
While Gorman said he expects performance to improve as volumes recover, “we continue to explore strategic structures that may make sense for us as we move to an institution which is less able to prosecute on the acquisition of physical assets and more focused on the trading side of the business.”
The future of the business will depend on regulations that have not yet been finalized, Gorman said.
Morgan Stanley declined to comment beyond what executives have said publicly. The sources spoke on the condition of anonymity because they are not authorized to speak on the matter publicly.
Although the banks say they should be allowed to own physical commodity trading assets because of an exemption granted to investment banks in a 1999 law, it is unclear how much the Fed will allow - particularly after an unexpected uproar in Washington last month over their deep role in commodities.
After a high-profile Senate banking committee hearing questioned whether banks should be allowed to own pipelines, warehouses and other commercial assets, a small but vocal cadre of critics have stepped up calls for pushing banks out of the physical trading and investment business.
“The Fed should do this, and if they don‘t, Congress should,” Bart Chilton, a Democratic member of the Commodity Futures Trading Commission, said on Monday.
Amid the tumult, JPMorgan announced plans to sell or spin off its physical commodities trading arm, an abrupt about-face after five years and billions of dollars worth of acquisitions. The decision followed a months-long review, and was prompted in part by the uncertain regulatory outlook for the business.
Since last year, finding a buyer for Morgan Stanley’s business has only gotten harder. In addition to JPMorgan’s division, smaller energy trading operations including Hess Energy Corp’s Hetco and privately held Gavilon have also been put for sale.
A letter from Morgan Stanley to the Federal Reserve in September 2012, obtained by Reuters under the Freedom of Information Act, showed the bank is still in discussions about conforming or divesting activities that fall outside the normal scope of financial holding companies.
Morgan Stanley has the longest pedigree of trading physical commodities of any Wall Street institution, with large and active physical oil and electricity desks stretching back to the early 1990s. In 2006 it bulked up the business by buying TransMontaigne, a large oil terminal and transport firm.
The bank said in June that it would trim its commodities division by exiting areas such as trading of agricultural products, freight and some European power and gas.
But facing an uncertain future, some of the bank’s other 75-plus traders in core areas such as oil are also looking elsewhere. Two of its top European crude oil traders, Pasi Siitonen and Simon Hutchinson, left the bank last month to join merchant commodity trader Noble Group.
“For a long time, commodities trading was a huge source of profit for these banks going back to the 1990s,” said James Malick, a partner at The Boston Consulting Group who provides strategic advice to financial firms. “But it’s just a very different space now and it’s not nearly as attractive for banks to remain in the business, especially in physical commodities.”
Malick pointed out that under new trading rules, the amount of money that has to be set aside to cover losses on complicated commodities derivatives trades goes up by 200 percent. That added buffer reduces profit in what used to be one of the most lucrative areas of commodities trading.