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Margin requirements - how strict?

As the country continues to dig its way out of financial crisis and legislation for market oversight takes shape, a group of market “end-users” testified before the Senate Agriculture Committee on Nov. 18.

The group of four — representing smaller, rural businesses as well as those that operate on a global scale — warned against too-strict regulations on derivatives trading and onerous capital/margin requirements.

(For the testimony of Gary Gensler, Chairman of the CFTC, before the committee see Reforming financial markets.)

Acting as a counterweight on the panel, Robert A. Johnson, director of Economic Policy at The Roosevelt Institute, argued against most of the exemptions sought by end-users.


The National Rural Electric Cooperative Association (NRECA) “is the not-for-profit, national service organization representing nearly 930 not-for-profit, member-owned, rural electric cooperative systems, which serve 42 million customers in 47 states,” testified Glenn English, NRECA CEO. “I should also note that for the states represented by the senators on this committee alone, NRECA has 21.6 million members and 494 electric co-ops.”

NRECA’s electric cooperative members “need predictability in the purchase price for their inputs if they are to provide stable, affordable prices to their customers. Rural electric cooperatives use derivatives to keep costs down by reducing the risks associated with both volatile energy prices and financial transaction costs.

“It is important to understand that electric co-ops are engaged in activities that are pure hedging, or risk management. Our consumers expect us, on their behalf, to protect them against volatility in the energy markets that can jeopardize small businesses and adversely impact the family budget.”

Neil Schloss, Ford Motor Company treasurer, told the committee “derivatives are integral to our business: the manufacture, sale, and financing of vehicles worldwide. Ford Motor Company is a global automotive industry leader that manufactures or distributes automobiles across six continents. We have about 200,000 employees and about 90 plants worldwide. The company provides financial services through Ford Motor Credit Company.”

As of Sept. 30, said Schloss, “we had about $108 billion of derivative notional outstanding, including: $93 billion of interest rate derivatives; $14 billion of foreign exchange derivatives; and $1 billion plus of commodity derivatives…

“Only a small fraction of our derivative trading relationships require us to post margin; instead, the common practice is that we pay an upfront credit charge commensurate with the risk of the underlying transaction.”

Since 2005, Southwestern Energy Company has invested over $6.5 billion in its operations, all located in the United States. “These investments have resulted in substantial domestic job creation, increased direct and indirect business expansion, and significant federal, state and local tax revenues,” testified Mark Boling, executive vice president and general counsel with Southwestern.

“Within our company alone, we have increased our employee base from 248 employees at year-end 2004 to approximately 1,500 employees today, an increase of over 600 percent.”

The ability to make over $6.5 billion of capital investments and create jobs was “primarily due to our ability to generate a reliable cash flow from the sale of our natural gas production and to gain access to additional funds borrowed under our bank revolving credit facility. The ability to generate a reliable stream of cash flow was due in large part to our use of (over the counter) OTC derivatives to lock in natural gas prices. Southwestern uses these derivatives as a risk management tool for our natural gas, a commodity that we produce, own, possess and market — we do not use derivatives for speculative purposes.”

What would be the result if independent energy producers are required to clear or post cash margin for their hedging transactions?

“Southwestern has typically hedged 60 to 80 percent of its expected natural gas production volumes for the following year,” said Boling. “Southwestern does not post collateral with any swap counterparty for a very good reason: natural gas swaps lower Southwestern’s business risk and makes it a much more stable company.”

Imposing mandatory clearing and margins on Southwestern’s hedges “would cause a significant drain on working capital at a time when capital is highly constrained and credit is in short supply. There will be a liquidity drain on those companies that have taken a conservative business approach by choosing to prudently hedge their economic risks. Mandatory margining will have the unintended consequence of actually increasing financial risks as companies choose not to hedge due to working capital constraints.”

In addition, warned Boling, “Increasing hedging costs by forcing all standardized derivative trades onto a clearinghouse will result in fewer market participants, more price volatility, and less price discovery.”

Jeff Billings, manager of risk management with the Municipal Gas Authority of Georgia — and also speaking on behalf of the American Public Gas Association (APGA) — also urged the committee not to jump at legislation that would prove prohibitive to his industry.

APGA is the national association for publicly-owned natural gas distribution systems. There are some 1,000 public gas systems in 36 states and over 720 are APGA members, said Billings.

“Publicly-owned gas systems are not-for-profit, retail distribution entities owned by, and accountable to, the citizens they serve. They include municipal gas distribution systems, public utility districts, county districts, and other public agencies that have natural gas distribution facilities.

While APGA has a history of being in favor of strengthening market oversight, “proposals that would require all standardized OTC derivatives transactions to be cleared would significantly impair the financial ability of public gas systems to engage in these gas supply strategies. Under current practices in the OTC markets, many public gas systems based upon their very-high creditworthiness are not required to post collateral as long as a gas system’s exposure stays below a predetermined threshold.”

Further, “the proposed mandate to clear all standardized OTC derivatives transactions would increase costs for public gas systems and their municipalities; an increase which would be borne 100 percent by their consumers. By way of example, in the case of the Municipal Gas Authority of Georgia, we have determined that based on our current hedge positions, mandatory clearing would require us to post initial margins in the range of $163 million to $243 million.”

The counterweight

Johnson, striking a marked contrast to his panel-mates, appealed to the committee not to soften the market legislation. “The American people clearly sense that there is something deeply flawed in the current structure of our financial markets and the political process that has spawned them. … ‘Too big to fail’ is a demoralizing eyesore that even CEOs of the largest firms agree must cease to exist. Losses of wealth, lost employment and economic activity and bailouts totaling trillions of dollars around the world are strong evidence of the failed structures of financial markets in their current form. The financial sector’s calamity has spilled over and done great harm to the lives of many Americans and people throughout the world.”

Johnson said at its core the current financial crisis exposes four problems:

• Excessive leverage.

• Opacity and complexity rather than transparency and simplicity.

• That ability to buy insurance without an insurable risk.

• A misalignment of incentives where the private incentive to take risk exceeds the social desire to bear risk.

To remedy this it is time “for a thorough redesign of these market systems to enhance the real potential of derivative instruments and the repair the obvious flaws in structure have caused so much harm.”

Johnson admitted surprise at “the intense focus on end-users of derivative instruments.” That focus has “substantially misdirected energy away” from both financial reform and the “large financial institutions in creating that crisis.”

What Johnson termed “a diversion” to end-users “is a dangerous exercise for at least two reasons.

“First, efforts to legislate what types of institutions are exempt from the restrictions of healthy market practice runs the risk of creating loopholes large enough to fly a jet aircraft through. End-user exemptions that are drawn too broadly serve to allow anyone and everyone to claim them, especially the large and too big to fail financial institutions that stand next to the public treasury.

“Second, the exemption of certain classes of financial products such as foreign exchange forwards and swaps, or any products that are traded on foreign platforms will surely serve to drive more activity offshore, perhaps to locations where the underpinning market structures are themselves unsound. This is akin to the process where manufacturing employment moves to where proper labor rights and environmental restrictions are not present. The movement of resources offshore leads to private profit at the expense of greater pollution and social harm.”

Hard numbers

Arkansas Sen. Blanche Lincoln, chairman of the Senate Agriculture Committee, asked the panel’s end-users if exemptions should be permitted and “where would you draw the line between the less- and more-significant players?”

Because NRECA is so small, said English, “some of our members have formed an entity … that does this kind of hedging for our membership. Earlier this year, we had about 18 of our members who were hedging. If they had to go to a clearing device … they likely would have to come up with $300 million to $400 million to cover what we anticipate would be the margin calls.

“Look at 5 percent and you’re talking about, roughly, $15 million that those 18 would have to incur in additional expense.”

Ford uses “OTC derivatives to hedge an underlying business risk generated from the selling of cars made domestically and shipped foreign, or vice versa,” said Schloss. The company employs “interest rate hedging from the standpoint of our ability to continue to fund our customers and dealers. There’s an underlying business risk. If we aren’t able to hedge, we’re making a risk trade-off.”

Internally-generated estimates have been compiled to see what Southwestern Energy Company would face if clearinghouse requirements proposed in some legislation are made law, said Boling. If such laws had been “in effect on June 30, 2008, we’d have been required to post $740 million in cash margins. By the end of the year, because of the volatility in prices, that would have changed down to $118 million. Just to put these numbers in context, as of Dec. 31, 2008, our company’s total debt outstanding was $735 million.”

Standing firm

Lincoln asked Johnson what he made of the end-users arguments. “Are you adamantly opposed to any exemption?”

Johnson said he was “less intimately familiar” with the businesses represented at the witness table and had “no basis to dispute them on individual costs.

“As I say in my written testimony, I do believe we have had a system reliant on the guarantees of taxpayers via the marketplace with ‘too big to fail’ institutions and we’ve had underpriced insurance. As each of them discusses the change to an exchange or clearinghouse would, in all likelihood, be more costly in obtaining that insurance. It would be more costly in the cash management realm.”

Some would go without insurance and resulting consequences “would likely be diminished profits in their sector or their firms. It would also likely be the case that their pricing would pass through to their customers.

“But philosophically … that is the removal of a subsidy,” said Johnson. “It might have been what we call an ‘implicit design,’ not something we all sat down and said, ‘we want to subsidize this credit.’

“If you move to exchange trading, I would anticipate we’d experience a narrowing of spreads, more transparency of market prices and integrity of the system that would diminish the contingency of a big, wipeout-like crisis that we’ve just had. That indirectly should be factored into their costs.”

Full transparency?

Georgia Sen. Saxby Chambliss, ranking member, then asked the end-users if, regardless of whether they receive an exemption, they’re willing to be “fully transparent” about swaps and derivatives they enter into. All agreed they would be.

“You all deal with financial institutions or sellers of products,” said Chambliss. “If you have the benefit of the full transparency of all their transactions prior to you engaging them … would the information you’d glean effect your ability to make a decision on whether or not (you’d) make a prudent investment?”

English: “Yes.”

Schloss: “To the extent we could get more transparency into the credit charges, I think that would be a help. The market itself is pretty transparent already. … The difficulty will come when you have the specialized trading — in our case, the securitization world.”

Boling: “Our company has a formal commodity risk management policy. As part of that, we engage in credit analysis of all the counterparties we use. So, that’s an ongoing thing for us because we’re concerned about their particular credit exposure ... as well making sure of the financial integrity of each. Anything that would allow us to do that job more effectively, we’d support.”

Billings: “Anything that would help shed light ... would help us on the front end.”

Johnson, said Chambliss, “makes a good point about making sure there is security in the market. And it is like buying an insurance policy — I think that’s a pretty good analogy. But I’m concerned about the practicalities each of you has alluded to.

“When we move forward, whatever legislation we end up with, I don’t want to create an opportunity for additional CDS to collapse the market 10 years from now.”

e-mail: [email protected]

TAGS: Management
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