A TRILLION UNINTENDED CONSEQUENCES / THE WALL STREET JOURNAL REVIEW & OUTLOOK ( HIGHLY RECOMMENDED READING )

REVIEW & OUTLOOK

JULY 6, 2010.

A Trillion Unintended Consequences

Dodd-Frank's last minute assault on Main Street derivatives

The Dodd-Frank bill remaking American finance hasn't yet become law, but corporate treasurers are already bracing for its impact. In the days surrounding this fall's election—after the close of the September 30 quarter—expect a series of warnings on liquidity from companies that had nothing to do with the credit panic and are not even in the finance business.

It could be an eerie replay of ObamaCare, whose passage triggered a series of charges by public companies facing higher retiree health-care costs. If Dodd-Frank passes the Senate, U.S. companies could be forced to put up an additional $1 trillion in collateral to continue using derivatives to reduce their business risk.

That estimate comes from the International Swaps and Derivatives Association. Yes, the group includes Wall Street derivatives dealers, but we're hearing a similar message from Main Street. Tom Deas, treasurer of the chemicals manufacturer FMC Corp., reports that companies like his will need to post hundreds of millions of dollars in additional margin—cash or committed credit that cannot be used to build plants, hire workers, or fund research and development.

"Nobody ever did a cost-benefit study of the effect of this bill on end users," he says, adding that "a treasurer at an energy company just told me that his firm will have to put up $1.5 billion."

We are not talking about a provision that never received discussion or debate prior to its inclusion in the bill. This idea was discussed, debated and rejected—that is, until Congressman Barney Frank and Senator Chris Dodd pulled an all-nighter to finish the bill before an arbitrary political deadline set by the White House. Sometime between midnight and 4 a.m. on Friday, June 25, Mr. Frank added this attack on Main Street companies to the bill.

Even many of the lawmakers still awake and participating in the conference committee were not aware of the Frank gambit, nor would they have necessarily expected it. Mr. Frank was supposed to be representing the House in these negotiations. In December, a bipartisan majority rejected this provision when Mr. Frank tried to include it in the House version of the bill.

Industrial companies were shocked to learn the details of Mr. Frank's midnight raid on their treasuries. Last week, Representative Spencer Bachus (R., Ala.) sounded the alarm on behalf of the U.S. economy and forced a vote on rewriting the bill, but the Democratic majority defeated his amendment on the floor.

To be clear, demanding more collateral, or margin, is a good idea when banks are dealing with other financial firms speculating on various price movements. But extending these requirements to commercial companies that are simply trying to manage their risks could needlessly suck cash out of productive parts of the economy.

FMC provides a good example. The company sells a lot of agricultural chemicals around the world, often in barter deals to cash-strapped farmers. In Brazil, say, farmers might trade FMC a portion of their expected soybean crop in return for a load of pesticides. FMC does not want to hold the risk of falling soybean prices, so it buys a derivatives contract tied to the date when the farmer is to deliver the soybeans. Under a typical deal, a bank agrees to pay FMC the difference if the price falls between now and when FMC takes delivery. Meanwhile, FMC agrees to pay the bank the difference if soybean prices rise.

None of this creates systemic risk. If the company has to pay because prices rise, no sweat. It has the soybeans and can sell them at the new higher price. The same is true for airlines that hedge their exposure to fuel prices. The moments when they pay the bank are the ones when oil prices are low and therefore less cash is needed to buy jet fuel.

The Beltway crowd says that industrial companies will save money once more such derivatives are traded on exchanges. But for creditworthy companies that are now able to demand good terms from banks, the savings from exchange trading may amount to a couple of basis points on the cost of a contract, measured against perhaps hundreds of basis points of new collateral required. That's just a guess, because particular margin requirements will be set by federal regulators, consistent with Dodd-Frank's overall approach of giving ultimate discretion to the Washington bureaucracy.

The harm could fall especially on U.S. workers. Much of the current over-the-counter derivatives market exists to manage currency risk—products sold overseas are bought with euros or yen or pesos, which are then converted to dollars to pay the U.S. workers who made them. If hedging currency risk becomes too expensive, companies may shift more jobs to countries where the purchases occur, matching their revenues to expenses in the same currency.

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Now that the House has passed Dodd-Frank, Democrats realize that they can no longer amend the bill without making both chambers go back to square one. So various Democrats have offered to write letters explaining to regulators that they never intended for these onerous rules to apply to commercial end users. As if a note on Congressional letterhead would override a statute passed by Congress and signed by the President. Expect lawsuits galore.

There's a better way to fix this problem: Vote against Dodd-Frank. If Senate Republicans hang together in opposition, Main Street can be saved from Washington's "Wall Street reform."

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