Derivative reform offers its own risks

by Russ Wiles The Arizona Republic May. 16, 2010 12:00 AM

Financial-reform legislation being debated in Congress aims to rein in the wild use of derivatives on Wall Street. Yet if certain proposals become law, everyday companies, including many in Arizona, also could get hog-tied.

Provisions involving derivatives are among the most contested parts of the legislation. They could open up the nebulous derivatives market to more scrutiny, force banks to spin off a lot of their business and push more trading onto exchanges.

Some measures could be beneficial, especially those giving regulators and the public more insight on how much trading is going on. But critics complain certain provisions could create a less efficient market and make it tougher and more costly for mainstream companies to hedge their risks.

The debate affects the many Arizona companies that use derivatives to guard against rising interest rates, minimize currency fluctuations, stabilize energy costs or lock in the prices for future output. Of 25 publicly traded Arizona-based companies examined by The Arizona Republic, 16 reported current or recent use.

Derivatives are instruments that take their value from something else, such as movement in an interest rate or commodity price or a changing relationship between currencies.

Like homeowners, for example, many firms dislike making payments on variable-rate debt and use derivatives to convert it into fixed payments.

"(We) may enter into interest-rate swap agreements, which convert (our) floating-rate debt to a fixed rate," said Mobile Mini, a Tempe-based maker of storage units, in a recent financial report.

Many types of derivatives can be created, limited only by a person's imagination and ability to find interested buyers. Banks are the ones that do the thinking and enter into deals with "end users."

Derivatives have taken a bad rap for destabilizing companies and even the economy as a whole. Credit-default swaps - a type of contract that allowed big bets on housing prices - triggered problems at Bear Stearns, Lehman Brothers and AIG.

Derivatives can be dangerous if done for speculative reasons and souped up with leverage. Yet this isn't the way Arizona companies participate.

"Most corporations use them to try to take some of the risk out of their cost and revenue structure," said Ed Lang, treasurer of waste-hauler Republic Services.

The Phoenix-based company occasionally enters into derivative contracts to hedge against rising fuel prices for its garbage-truck fleet and to lock in future prices for the used cardboard, old newspapers and other commodities that it recycles.

"I'm paying a fee or cost to protect my earnings stream," Lang said, likening his firm's use to an insurance policy.

Commodity producers such as mining firms Freeport-McMoRan Copper & Gold and Southern Copper use derivatives. So do firms with foreign operations that deal in multiple currencies, such as First Solar.

They're also popular among utilities.

"UniSource Energy and its subsidiaries use derivatives to protect against price swings in the future cost of fuel and energy and to stabilize the interest-rate expense associated with certain credit instruments," said Joe Salkowski, a spokesman for the Tucson company.

Derivative values show up on corporate balance sheets. Gains and losses from trading get carried to the income statement.

US Airways cited gains of $245 million in 2007 from hedging aviation fuel costs, followed by a loss of $356 million in 2008. The company reported that it hasn't entered into new contracts since late 2008.

Derivative use by Arizona companies usually doesn't impact the bottom line much. These firms are hedging, not speculating, and most hedge selectively - protecting against some risks, some of the time.

The reform legislation could make it harder and more costly to hedge. In part, this is because some proposals would push more derivatives trading to exchanges, and companies would have to use standardized contracts.

Many end users prefer customized deals so they can hedge exactly what they want, how much they want and when they want.

"It's like having to buy home insurance in $100,000 increments," said David Daughtrey, a former investment banker who's now an adviser at Copperwynd Financial in Scottsdale.

"If your home is worth $250,000, you'd have a problem."

Exchange trading could prove more costly by forcing companies to hedge less efficiently, requiring more collateral or mandating that cash only could be used as collateral.

"End users should not be forced to post cash collateral that could otherwise be used to grow their businesses, make productive investments, create jobs and compete in the global economy," said Alexander Cutler, chairman and CEO of Eaton Corp., in a recent letter to Congress.

Another controversy involves the proposed mandatory use of clearinghouses.

In a private derivatives trade, there's a danger the opposing "counterparty" might renege on its obligations and fail to pay up.

Clearinghouses aim to reduce this risk by effectively taking over each trade, becoming the buyer if you're the seller or the seller if you're the buyer.

That cuts the risk of broad turmoil from the failure of a single entity.

"If one counterparty has a problem, it wouldn't become a domino," Daughtrey said.

This notion makes sense, but there are concerns. For instance, one proposal in Congress would restrict the amount of ownership in clearinghouses by "swap dealers," namely banks, yet these are the firms with the capital and know-how to make the markets function. Other proposals could undermine the role of banks in the derivatives market generally.

Arizona companies are still trying to figure out what it all means for them.

Lang said he didn't believe that Republic Services' derivatives use would be affected much. "It might make it a little less attractive," he said.

But Salkowski said UniSource is concerned about possible new costs.

Derivatives used by the firm don't contribute to the systemic risk the legislation seeks to address, he said, "So there is no justification for the imposition of new costs that would ultimately be passed along to our utility customers."

The final shape of derivatives regulation still isn't known. The House passed its bill last year, but the Senate hasn't voted on its likely version. Differences between bills would have to be ironed out. Meanwhile, lobbying continues.

But one thing is certain: This isn't just a Wall Street issue. How it plays out also could affect companies in Arizona and elsewhere.


Derivative reform offers its own risks