Agribusiness Freedom Foundation  
Home arrow Sentinel e-Newsletter arrow July 2009 arrow Derivative Proposal Counterproductive, Non-Targeted Overreaction
Main Menu
About AFF
Latest Op/Ed Release
Sentinel e-Newsletter
Newsletter Signup
Staff Bios
Make A Contribution
Contact Us
Derivative Proposal Counterproductive, Non-Targeted Overreaction PDF Print E-mail
Written by Steve Dittmer   
Wednesday, 29 July 2009
AFF Sentinel Vol.6#22

While the public rouses from its political slumber over energy and health care bills, other "reforms" are looming that could cost business and consumers dearly.

In typical government fashion, the very things the administration claims it doesn't want to do would be exactly what it would force. With tight credit, increased risk, increased volatility and a reduction in capital to finance business and jobs, proposed legislation would exacerbate those conditions. Some bailed out financial institutions might be the only beneficiaries of proposed legislation.

Treasury Secretary Timothy Geithner told the House Ag and Finance committees he didn't want to ban customized over-the-counter (OTC) derivative contracts but then later said his definition of standardized contracts would be broad and "designed to be difficult to evade," ("Geithner: Business Hedging Isn't Target," Wall Street Journal, 07/11/09). Rep. Frank Lucas (R-OK) said Treasury would actually be, in effect, eliminating OTC contracts, jeopardizing risk hedging and increasing price volatility.

Could this blunderbuss approach be previewing Administration plans for regulation of agricultural contracts, processors and producers?

What's the problem? Take some complex financial instruments, add in fear and misunderstanding and a big bailout in a country tired of bailouts and one has a recipe for real problems for companies who need to manage business risk and volatility.

Think "derivatives" and some folks think Lehman Brothers and AIG. AIG's problems were with mortgage-backed securities and collateralized debt obligations, not derivatives. Compared to AIG's tens of billions in credit swap exposure, derivative liabilities from Lehman were settled quickly for a relatively paltry $6.2 million, Rep. Scott Garrett (R-NJ) told The Hill. Derivatives were not the problem, Garrett said, and attacking derivatives with more regulation will not solve problems elsewhere.

Small and large companies have used OTC derivative markets for decades to transfer risk and reduce volatility in commodities and interest -- causing no problems. Some businesses use tailored, OTC derivative contracts because they need non-standard protection and offer non- standard collateral -- as opposed to the futures markets, with rigid structure and liquid capital requirements. Hedging risk through derivatives, for example, enables an oil company to pledge reserves as collateral without tying up exploration capital.

Independent gas and oil producers account for over 80 percent of domestic natural gas and 65 percent of American oil, Barry Russell said, CEO of the Independent Petroleum Association of America, writing to Speaker Nancy Pelosi. Many independent producers hedge their risk through the OTC market, often under requirement from their bankers, and sometimes the bank handles the hedging.

In line to be hurt are agricultural suppliers, manufacturers, exporting firms, airlines, oil and gas producers, car dealers - in fact - Rep. Mike McMahon (D-NY) said 29 of the Dow 30 use derivatives. And larger companies use derivatives to offer protection to smaller customers, who otherwise would find risk management more difficult and expensive.

Cargill, for example, a big company, uses derivatives in food and agricultural markets, and then turns around and offers risk management products to commercial agricultural and energy customers and producers, David Dines, president of Cargill Risk Management told the Senate Agricultural Committee. Dines noted that during a great economic crisis and the "most volatile commodity market Cargill has ever seen, OTC contracts in agriculture, energy and foreign exchange markets performed well, did not create systemic risks and, in fact, helped many end-users manage and hedge their risks during this very difficult time."

It would be helpful, derivative users said, to aggregate and publish information already gathered by multiple government agencies. Improvements are needed in financial system regulation. Banks demonstrated current regulations didn't prevent risky activities.

But proposals extending bank-like regulations to non-bank businesses using derivatives -- by applying capital requirements and margin requirements -- would cause serious harm to financial markets and thousands of non-financial businesses that America needs for growth, Garrett said.

Capital-intensive industries like energy and agriculture do not need such stresses and job threats. Dines points out the legislation would - by draining capital - punish those who "have taken conservative business approaches" to "prudently hedge their economic risks."

There are two likely outcomes from the derivative regulations being proposed: a) risk management would become more expensive -- reducing capital for growth and stressing companies - making business failures more likely, or b) companies would be forced to fly naked, without risk protection, again making failures more likely.

America does not need this "solution." Passing on the increased volatility and costs of un-hedged risks and commodities to consumers is unacceptable. We hope Congress sees fit not hurt agriculture, transportation and energy companies as well as U.S. consumers.

Email your comments to the author


Last Updated ( Friday, 31 July 2009 )
Next >
designed by