An ambitious bill to tighten regulations and oversight on financial markets passed the House Agriculture Committee Feb. 12. Prior to the bipartisan voice-vote that passed the bill, Chairman Collin Peterson said the legislation was sure to “upset” many on Wall Street, something that seemed to cause him little worry.
For months Peterson warned that a turf battle over financial market regulation was brewing. While there still may be some jostling with several congressional committees — including the House Financial Services Committee — on the best method of market oversight, Peterson's committee threw its backing to the Commodity Futures Trading Commission. Under the proposed rules, the CFTC would have expanded authority including criminal prosecution power over those that violate antifraud rules. The new bill also removes the Federal Reserve from regulating the derivatives markets.
The committee's elbowing aside of the Federal Reserve shouldn't surprise anyone who has followed the hearings. “I share the concerns of those who think the Fed controls too much already,” said Peterson during a Jan. 28 hearing. “They're an unelected body that sets monetary policy. … Now, they're printing money for the bailout. I'm not surprised that the large banks are clamoring for the Fed to regulate revenue activity given their cozy relationship with Fed members. Plus, they probably think it's a good idea to have a regulator with resources to bail them out if things go wrong.”
Peterson also expressed strong opposition to the Securities and Exchange Commission having “primary authority over (derivative) contracts. The SEC uses a rules-based system that's behind the curve of today's modern, complex financial products. In my opinion, that's just not workable. They aren't just trying to solve yesterday's — or last week's — problems, they're still trying to solve last decade's. As a result, they've done a poor job.
“How much confidence do we have in an agency that repeatedly ignored calls — even within the agency — to examine the investment advisory business of Bernard Madoff, which turned out to be the biggest Ponzi scheme in history?”
At the same hearing, Tom Buis, president of the National Farmers Union (NFU), testified the extent market issues had impacted producers became apparent when “we began receiving numerous phone calls. Wheat prices hit record levels. Corn prices were in the record category, as well. Farmers were calling to say they couldn't market their grain the way they normally have — by and large, by pricing grain after harvest for delivery. When precluded, they were told the reason is that many local elevators and co-ops were running up against credit limits. Commodity prices were going up the limit day after day and (elevators had) to meet the margin calls. Their only alternative was to quit offering futures contracts after harvest.”
Buis claimed the CFTC largely ignored warnings. When the NFU contacted the CFTC and urged them to take a look, a hearing was scheduled. At the hearing “they went through all the data and concluded, before the hearing was even over, that nothing out of the ordinary was happening.”
Well, something out of the ordinary was happening, insisted Buis. “We were a little frustrated with the reactions. As the year went on, we began to find out more and more that what was really causing higher food prices and input costs was the excessive speculation in the commodity markets, whether you look at oil, grains, any of the inputs. … As a result, farmers and ranchers didn't get the high prices and had to wait for prices to come down at harvest in order to sell wheat and other commodities.”
Buis also pointed out “something I don't think anyone can explain: the cotton market virtually doubling overnight. Our impression is we have a lot of cotton in storage and it's difficult to move. As a result, it was definitely a speculative market that lasted a very short time. I've yet to meet a cotton farmer that got the 90-cent prices for their cotton.”
Growers were “impacted tremendously,” said Buis. And the market turmoil and uncertainty “caused a divisive attitude amongst agriculture producers because livestock producers were told corn and feed prices were going to go even higher. They had to lock in prices. I just got back from California and many of the producers there had to lock in feed prices because they believed all the speculative reports.”
Despite doing the “prudent” thing by locking in future feed uses, the California dairy industry is in as bad a “financial shape as I've seen. Ethanol companies did the same thing.”
Buis encouraged the committee to pass legislation establishing speculative limits for all commodities.
CDS, naked and otherwise
During committee hearings, credit default swaps (CDS) repeatedly surfaced as a prime reason for the current economic turmoil. The swaps — nearly $60 trillion by some estimates — allow market players to make money by predicting a company will default on a loan obligation. Critics of the secretive swaps say they are ripe for improper manipulation and have pushed for the transactions to go through a clearinghouse.
Even so, during testimony, many financial institution representatives pushed against regulating the CDS too much.
“A number of you mentioned the provision on the ban of naked credit default swaps (the holder of a naked swap does not own the underlying bond),” said Peterson. “Some don't like the idea. … One of the ideas is we'd only have the provision apply when the SEC bans the short-selling of stock. If that were the provision, would that change the (naysayers') position?”
“I'd continue to argue the ban would dry up liquidity at a time when we don't need that,” responded John Damgard, president of the Futures Industry Association.
“I'm sure the SEC has looked long and hard at their decision. They reversed themselves because the options industry came in and said, ‘this is the only way we can operate is if we can sell short.’”
Does that create a situation where people could move against a company if the SEC does have a short-selling ban?
“First of all, you must look at equities and credit as sort of opposite roles,” said Michael Gooch, chairman and CEO of GFI Group, Inc. “So, if you ban the short-selling of equities, you'd ban the buying of the credit derivatives. You buy the credit derivatives because you're basically buying protection against a default.”
Gooch said the concern is when the banning of short-selling in the financials took place, “it was sort of an emergency situation because we were in a death spiral which is contributed to by the mark-to-market rules on the banks. I'd say 98 percent of the time, I'd want to know what the assets my banks has are worth. But in certain, very unusual circumstances, it might be necessary to have some sort of circuit-breaker in place that would allow some breathing room (to prevent) the death spiral that occurred back in September when there was buying of derivatives and selling of equities — because that's where you'd potentially hedge the short credit derivative decision.”
Having listened to financial officers testify, Michael Greenberger, a law professor at the University of Maryland School of Law, urged the committee to take a hard line with the CDS. “Mr. Gooch talks about CDS buying protection. We're talking about naked CDS. With naked CDS, there's no need to protect. It's a guess that, in the case of subprime mortgages, the homeowner won't pay his mortgage. These get paid off if the collateralized debt obligations fail. The collateralized debt obligations are a security interest in homeowners paying their mortgages. These are people who don't have a security interest in that.
“John Paulson (a New York hedge fund manager), in 2007, took out these naked CDS and because there were so many forfeitures of your constituents, he was able to take home $4 billion that year.
“He was lucky because he got to the window when the people who were issuing the guarantees still had money. AIG ran out of money. And by the way, you and I and your constituents are now sending money in the front door of AIG and Citigroup and other concerns … so it'll go out the back door to pay the people who took a naked bet that homeowners wouldn't pay their mortgages.”
Because there are bets out there that have no reflection on the real economic debt “it's magnifying the problems by three-fold, some say eight-fold. In other words, more people are betting the mortgages won't be paid than there are mortgages.”
The naked CDS need attention “because it's a way to get around the regulated equity markets. If you think GM is going to fail, you go out and buy a naked CDS even if you don't own a bond in GM. Then, what do those people do? It's been reported they go out and take every action they can to encourage the failure of GM.”
In the case of insuring subprime loans, “when banks have tried to go in and renegotiate to allow people to stay in their houses, it hurts the people who have guarantees for failures. So they're bringing lawsuits to prevent that renegotiation.”
Naked CDS create the “grossest form of moral hazard,” continued Greenberger. “From 1789, when this republic was founded, to the mid-1990s, we didn't have CDS or naked CDS. I ask you: are your constituents, when you go home, saying, ‘please, please, please allow us to have naked CDS’? No! It's the bankers who got us into this problem who want the naked CDS. They should be banned and I believe if this committee doesn't do it, it'll be done by the SEC.”
Be careful, warned Terrance Duffy, executive chairman, CME Group, Inc. “When you talk about CDS in general, what we propose is to have a clearing mechanism which we think eliminates a lot of risk associated with these products. What's critically important for CDS or any other product is liquidity. If you don't have liquidity, bonafide hedgers won't be able to move in and out of their positions, at all because the bid offer will be so wide you won't be able to transact any business whether in grains, crude oil or CDS.”
“It seems to me, Mr. Duffy is absolutely correct,” interjected Damgard. “At a time when credit is so tight, anything that limits the liquidity of the credit market is a bad idea. I'm simply willing to debate Mr. Greenberger anytime but I don't know if this is the right place.”
Greenberger, exasperated, immediately jumped in. “Well, Mr. Damgard should debate not only Mr. Greenberger but Mr. Volcker and Mr. Greenspan (both former chairmen of the Federal Reserve), who said, ‘I made a terrible mistake when I allowed these CDS to be deregulated.’
“Mr. Damgard, the American public is flat on its back. They don't have a fancy suit and fancy tie and represent all these bankers. … The American taxpayer has now guaranteed $6 trillion of the banking system. A large part of that are unregulated CDS.”
Greenberger was equally exercised about the financial sector representatives' claims about liquidity.
“The liquidity here is being given by the American taxpayer — the CDS are operational today because we, as taxpayers, are giving AIG, Citigroup, Bank of America, Merrill Lynch, money to pay of these debts. They have no economic purpose, and they've dragged the country into the mire.”
There are estimates that for every one CDS ensuring real risk, “there are eight that are bets that homeowners will not pay their mortgages. That's a terrible thing that creates high moral hazard and (Chairman Peterson) is absolutely right in putting that provision in the draft discussion bill.”
Back to agriculture
Buis, sitting beside the warring factions, said the debate had “enthralled” him. Asked how things were currently looking for farmers, he showed less enthusiasm.
“I think this deregulatory approach, or lack of oversight by CFTC, led to it. Farmers thought they'd get good prices but were precluded from the market. Mr. Damgard is right: they ran up against their credit limits. But what he doesn't tell you is those markets were going up not due to market fundamentals but because of the tremendous amount of Wall Street money that came into those markets. Everyone saw this as a great opportunity to make money.”
When the bubble burst and commodity prices collapsed, “it impacted virtually every aspect of agriculture.”
Farmers “very much” remain in a losing position, said Buis. “And they're locked into these high costs — whether livestock producers (with feed) or grain producers who bought fertilizer based on record inputs. Fertilizer prices followed oil — and we all know that was a false bubble, as well.”
Also appearing before the committee, Gary Taylor, president, Cargill Cotton — and speaking on behalf of the National Cotton Council, American Cotton Shippers Association, and AMCOT — was asked where cotton farmers are after last year's “anomalies” in the cotton market.
“Things have normalized to some degree. But there's been so much stress and a number of our competitors have vanished. There's not the richness or number of offers for cotton. … It just isn't as robust and I'd say producers aren't receiving a traditional basis for the cotton they're selling.
“We probably took out 30 to 35 percent of our merchandising capacity in that one week.”
As for market regulation, “This is America and I believe everyone should be able to play,” said Taylor. “But everyone needs to play by the same rules. Positions need to be reported … people need to have consistent behavior and requirements in limits and all operate under the same rules.
“We're (advocating) for transparency, full disclosure, aggregating positions so we all know when an event is taking place and can prepare for it and the market can digest it. We certainly don't want to discourage participation. We need speculators in all our markets.”
Michael Masters, managing member/portfolio manager, Masters Capital Management, said claims aggressive oversight would disrupt market liquidity and send trading activity offshore was “an empty threat. The idea that folks will go offshore for all their trading has been promoted by the futures industry and other folks as a scare tactic to prevent necessary regulation in our markets.
“In fact, if they really want to trade over there, (maybe) we should buy them a one-way ticket. The bottom line is without significant government intervention with an AIG — at $110 billion — it's very likely our markets would have had a systemic meltdown. And fiduciaries today won't go to a place where they are worried about counterparties. … Folks don't want to trade with less transparency and regulation.
“Trustees of large institutional investors want to trade with more regulation and transparency. The United States should take the lead on that.”
To read the opening statements of those testifying before the House Agriculture Committee, visit http://agriculture.house.gov/hearings/index.html.