Betting the Business

In our last post on margins and end-users, we explained the fallacy at the heart of the complaint that a margin requirement would deplete an end-user’s scarce capital. A number of people have put the question to us, “If you are correct, then why are so many business interests lobbying so hard against the mandate?” It’s a fair question. We have been asking it in one version or another since the discussion on OTC derivatives reform began and the lobbying began. There are many approaches and aspects to the question, and, probably, many divergent answers. In this post, we’d like to raise just one point on the matter: just because many end-users oppose the mandate doesn’t automatically mean their arguments are valid.

We’ve been through this before. Those readers who are old enough to remember the 1990s will remember another political battle over how to deal with stock options granted as a form of compensation to employees.

Under the then applicable method for accounting for stock option grants, Accounting Principles Board (APB) Opinion No. 25, at-the-money options could be awarded as if they had a zero cost. Companies were able to give valuable compensation without charging an expense.

Of course the option grants had value. Of course, granting stock options as compensation was an expense to the firm. But the accounting did not correspond to the reality. When stock option grants had been few and small, this was not a big deal. But when option grants grew to become a major element of compensation, especially in certain industries and among senior management, the discrepancy between the accounting and the reality became too large to ignore.

In 1993, FASB, the professional accounting standards organization, proposed mandatory expensing of option grants.

Large portions of the business community were alarmed and initiated a massive public relations and lobbying effort to stop this. The claim was made that expensing options would discourage the use of stock options to reward performance and obstruct the effort to align the interests of the management and shareholders. The mandate would destroy the growth of the high tech sectors, costing Americans precious high end jobs. Cisco System’s CEO announced that “I think it will impact whether we grow headcount again to the same extent in the US or not”. A study by the Employment Policy Foundation was circulated among policy makers claiming that the loss to the economy would be more than $2.3 trillion over a decade. The world as we then knew it would end.

When the lobbying failed to persuade the accounting standard setters, the companies turned to Congress, threatening to legally undercut FASB’s authority.

In 1995, FASB backed down. What we then got was FAS 123, a watered down requirement for companies to either expense or at least disclose in the footnotes the impact of options awards on earnings per share.

Then came the dotcom bust and the WorldCom and Enron accounting scandals, among other events. The authority and aura surrounding the opponents of expensing flagged. The public came to see the flexibility in accounting standards in a new, unflattering light. More people understood the value of requiring that companies call a spade a spade.

In 2004, FASB issued a new rule, 123(R), finally requiring companies to expense option awards in their financial statements.

The economic calamity that had been forecasted to follow this requirement did not happen. Now, a few years later, the option expensing mandate is largely uncontroversial—at least as uncontroversial as any other accounting rule.

We believe the situation with regard to end-user complaints about margining their derivative trades is analogous. It is another case of individuals being enchanted with a form of financing that seems costless only because it is off-balance sheet. Just because costs are not disclosed doesn’t make them disappear: they are there and they are real. Recognizing the costs does not create the costs. On the contrary: what often creates unnecessary costs is the refusal to be up front and transparent about them, whether in the design of nonsensical accounting rules or in the crafting of exemptions in regulatory regimes. Mandating margining does not raise the costs of hedging. The forecasts of dire economic consequences are unfounded.

As regulators tasked with implementing the Dodd-Frank reform of the OTC derivatives market continue the task of drafting regulations, debate continues surrounding the issue of whether end-users will be forced to post margin on their swap transactions. We addressed the central economic points in a series of posts last fall–(1) (2) (3) (4). Since then we returned to the issue as it occasionally popped back onto the radar screen. In the wake of new draft rules released in mid-April, we thought it useful to take stock once again.

There are two separate components of the Dodd-Frank reform that are the primary focus of this debate.

First, there is the mandate for a large portion of swaps to be cleared in a central counterparty clearing (CCP). Clearing entails margining.  So a clearing mandate applied to end-users would require end-users to post margin. However, the law specifically exempts end-users from the clearing mandate. Debate continues over how the implementing rules will define an end-user. Everybody wants their own trades to qualify under this exemption.

Second, there is the mandate for swaps not cleared in a central counterparty clearing (CCP) to nevertheless be margined. The draft rules released earlier this month pertain to this mandate. The CFTC’s proposed rules exempt end-users from the mandate to post margin on uncleared swaps. Banking regulators—the Federal Reserve, FDIC and others—proposed rules that exempt end-users up to a certain threshold exposure, after which margin must be collected. These draft rules are now up for comment.

A variety of business interests continue vigorous lobbying campaigns targeted to expanding the end-user exemption from the margin requirement. Why?

The main argument goes something like this…

1. in the old, unregulated OTC derivatives market, end-users could negotiate a swap with their dealer banks without any requirement to post margin;
2. a requirement to post margin depletes an end-user’s scarce capital;
3. this raises the cost of hedging and doing business; companies will be forced either to hedge less and become riskier, in turn increasing the overall risk in the system; alternatively, costs will go up , companies will be less competitive and jobs will be lost.

In the next post we’ll examine this argument.