After a near-fatal fall, the U.S. financial system has moved from the emergency room to intensive care, where the doctors in Congress, the administration and regulatory agencies are searching for therapies to return the patient to healthy vigor and a new regimen to prevent a deadly relapse from occurring. Legislation that was mired in controversy has recovered momentum and now seems likely to transform corporate treasuries' relationships with commercial banks, investment banks, insurance companies, investment companies, rating agencies and even shareholders. For better or worse, treasury teams will have to use different tools, negotiate different deals, find different strategies and rerun cost-benefit analyses to stay on top. They face a once-in-a-professional-lifetime challenge.
Fear is widespread that political expediency will push Congress and regulators to overreact. Tom Deas, treasurer and vice president at $3 billion FMC Corp., a Philadelphia-based chemical company, laments that "not one committee or agency or government economist has tried to calculate the cost to end users of their derivatives trading reforms. They haven't attempted a cost-benefit analysis, and we don't think the trade-off is there."
Troubled that provisions in Senate bills would drive up hedging costs by requiring banks to hold reserves against uncleared over-the-counter derivatives, Deas is indignant about congressional resistance to grandfathering existing derivative contracts.
"We've already paid the banks once for their credit risk because they build that into the price of the derivatives. If we're not grandfathered and have to pay banks again for credit risk because of new margin requirements, we'll be paying twice for the same risk," fumes Deas, who is also executive vice president of the National Association of Corporate Treasurers (NACT).
Deas opposes breaking up large banks as a way to prevent too-big-to-fail. "Think about leveraged borrowers," he says. Lenders typically require those borrowers to fix half of the interest-rate risk on their loans through swaps with banks in the credit group. They have collateral-sharing agreements that permit the efficient use of assets as collateral. If these lending banks had to divest their derivatives trading desks into separately capitalized subsidiaries, borrowers would lose the efficiency of collateral sharing, Deas explains.
Larry Corcoran, financial risk manager in the treasury department at $8.3 billion Air Products and Chemicals in Allentown, Pa., says he personally favors less government "but given the importance of the financial markets and their proven inability to manage risk themselves, some legislation may be necessary. I hope it will be minimal and not overreaching."
Others worry political considerations are pulling Congress and regulators to do too little. Sen. Chris Dodd (D-Conn.) "caved to the Fed, Treasury, the [banking] industry and special interests," charges Bill Isaac, former chairman of the Federal Deposit Insurance Corp. (FDIC) and now chairman of LECG, a global advisory firm. "If the Dodd bill had been law in 2008, it would not have prevented the crisis," he says. "It will do nothing to prevent the next crisis. It does not deal with underlying causes. He settled for weak, ineffective reform." For Isaac, the core problem is the fragmented, ineffective bank regulatory system.
"Last fall, [Dodd] wanted an independent agency with authority over all the existing financial regulatory bodies," Isaac says. "That was the right move, and I supported it. But then the industry and the regulators pushed back and he backed down. Putting the existing regulators on a council to oversee themselves makes no sense. Talk about hiring the fox to guard the hen house."
Isaac argues that the Dodd and Frank bills are "evil twins" because they are equally ineffectual. "After all the attention, Congress will pass a bill, call it reform and move on to the next issue, leaving the illusion that we have done something when we haven't," says the former Reagan appointee, who headed the FDIC during the heyday of deregulation.
Although corporate treasuries may be profoundly affected by the outcome of financial reform, treasury professionals have concentrated on one issue that has the most obvious and direct impact on their day-to-day operations--access to over-the-counter derivatives. "That's what our members mostly were calling about, although they have some concern about the credit rating agencies piece," says Cady North, manager of government affairs for Financial Executives International (FEI). "They're not opposed to reform, but they want reform that hurts them as little as possible."
Treasury pros may be reluctant to talk about the broader implications of financial reform because the issues are controversial and "they don't want to jeopardize their careers by seeming to speak for their companies," observes Jeff Wallace, managing partner of Greenwich Treasury Advisors.
The bills pending in Congress contain broad exemptions for derivative end users, but questions remain about how valuable that exemption will be when only one end of the transaction is exempt, particularly if collateral or capital requirements drive up the cost for dealers or force them into exchange trading. "Reform could kill the markets," cautions Rick Moss, treasurer of $3.9 billion Hanesbrands in Winston-Salem, N.C. "As a treasurer, you're always weighing the cost of holding risk vs. mitigating it. If mitigation is too expensive, we wouldn't hedge."
"If we have to put up collateral, that's money that can't be used to grow the business and create jobs," says James Haddad, vice president of finance at $852 million Cadence Design Systems in San Jose, Calif. "If banks, which are leveraged around eight-to-one or nine-to-one, have to put up collateral, that means that every dollar tied up in collateral removes $8 or $9 available for lending."
Air Products' Corcoran is leery of increasing visibility by forcing all derivative trades onto exchanges. "Now I can deal with whomever I want to get whatever tenor and amount I need for a hedge, and that gets us the accounting treatment we need," he says. "If we couldn't customize and hedge precisely, we'd have to revisit how we comply with FAS 133."
Haddad argues against using a broad brush to put the same limitations on all derivatives. "A currency forward is not a credit default swap," he says, and suggests creating multiple buckets according to risk and regulating each bucket differently.
But Wallace argues that it's time to bite that bullet and accept restrictions and cost increases. If banks have to collateralize their derivatives positions, there is "a legitimate fear that it would result in less hedging," he concedes, "but that is the price we have to pay for a safer system. Put the trades on exchanges, collateralize them, net things out and make it all transparent. That's the only way we can control bank risk.
"Banks have tremendous inventiveness at hiding their risks," Wallace adds. "We need to expose those risks and mark them to market, independently of what banks think they are worth. Since banks are unable to discipline themselves--and we cannot trust the regulators to remain awake and discipline them--society will have to discipline the financial institutions and, unfortunately, their non-financial counterparties through exchange trading."
Another bank bailout cannot be averted without reining in derivatives, he insists. "When you talk about too big to fail, you're talking about derivatives. The derivatives books dwarf the loan books," he notes.
Isaac admits he is "no fan of derivatives" and favors "trying to push most of the trading onto exchanges. There are some pretty big exceptions for end users in the bills, and that undermines the transparency they are trying to get." There may be viable middle ground in the debate over regulating derivatives. "It's better for derivatives to trade through exchanges," says Dave Robertson, a partner at Treasury Strategies. "The challenge now is to take the rich creativity of the over-the-counter market and give the derivatives qualities of exchange-traded transactions without killing them off."
Requiring derivatives to be exchange-traded does not mean that they all have to be standardized products, insists Carrick Pierce, president of Derivix, a derivatives trading software firm. "A nonstandard product can be quoted, traded and cleared in a transparent world," Pierce says. "Exchanges have been thinking about how to do this."
Meanwhile, Congress marches on. The House moved first, as Rep. Barney Frank (D-Mass.), chairman of the Financial Services Committee, ushered a bill through his committee that passed the full House last December with a 223-202 party-line vote. Not a single Republican voted for it.
Then attention shifted to the Senate, where Sen. Chris Dodd, D-Conn., chairman of the Banking Committee, introduced a bill on his own after failing to reach a bipartisan compromise with two Republicans on the committee. On a parallel track, Sen. Blanche Lincoln (D-Ark.), chair of the Agriculture Committee, which oversees commodities trading, moved a bill through committee with one Republican vote. But after fraud charges were brought against Goldman Sachs, igniting public opinion, the Republican filibuster threat crumbled. At press time, the Senate had plunged into a lengthy floor debate amid a growing consensus that a modified Dodd bill would pass, be reconciled with the House bill and be signed into law this year.
At press time, Senators were debating the Dodd bill that the Banking Committee had approved on a party-line 13-10 vote, reports Brian Kalish, finance practice lead at the Association for Financial Professionals. "The bill is not in final form," he cautions. "The strategy is to have the debate and work out the details on the floor of the Senate." For months solid Republican opposition put passage of a Senate bill in doubt, but that changed dramatically in late April, Kalish reports. "There is no way that 41 Republicans can stand together and vote against financial regulatory reform," he says. "It's not attractive politically to look like you are in the banks' pocket."
While treasurers would not argue in favor of moral hazard nor support keeping banks too big to fail, they are not above taking some comfort from it. "A lot of treasurers are saying that they don't care how Citigroup, for example, is rated. They know it won't be allowed to fail, so they don't avoid doing business there," Robertson says. Some refer to the 10 largest banks as "Club Fed" because they now carry an implicit government guarantee, he explains. The 10 next largest banks aren't necessarily in Club Fed, so there is more caution in using them, Robertson says. "Many treasurers like the idea of too-big-to-fail. It gives them some relief from counterparty risk pressures."
If a bank is too big to fail, the simple solution is to make it smaller, but big institutions will fight dismemberment, says Dan Borge, a director at consultancy LECG. But a corporate financing can be a complex transaction with many parts. If treasurers have to break big deals up into a number of smaller deals with unrelated third parties, it would take more time and probably cost more. Being able to fold many components into a single deal is a big convenience to give up.
As long as there are banks that are too big to fail and the U.S. government insures bank deposits, there will always be the prospect of the government bailing out banks that made bad judgments, Borge says. "The only solution would be breaking up large banks or adding regulation. The government has a legitimate interest in regulating the risk banks can take."
One thing treasurers want from reform is a more reliable way to gauge counterparty risk, and that won't be easy, Borge says. "Determining the creditworthiness of a counterparty is one of the most difficult challenges. That's why the rating agencies stumbled. There will be attempts to get the rating agencies to do a better job, but at the end of the day, when you do the transaction, you take on the risk that your counterparty might not perform."
But Treasury Strategies' Robertson points out that making banks smaller runs counter to current industry trends. Ending too-big-to-fail is "a pipe dream unless the government takes drastic action," Robertson says. "The crisis has forced consolidation and made the big banks even bigger."
Whether Congress gets it right could be critical. "If we had another meltdown, I don't know what would happen," Moss says. "We went into this one with a government that had the resources and ultimately the will to intervene and save the markets. With the deficits and the growing debt burden, I worry that if it happened again, the government might not have the resources or the political will to go through another bailout. That to me is the worst-case scenario."
For additional information on what the legislation might mean for finance departments, see More Viewpoints on Financial Reform.