By Dan Manternach, editor and publisher, Doane's FOCUS Report
Editor's Note: The financial reform package passed last week essentially sets up a new federal agency to 1) police consumer lending, 2) set up an early warning system for financial risks, 3) force failing firms to liquidate before they become "too big to fail," 4) require a government bail-out and 5) require previous "over-the-counter" financial instruments that have been largely uncontrolled to be traded on regulated exchanges and 6) set up new rules for OTC instruments that will remain uncontrolled otherwise. In this FOCUS, I've picked out elements of most interest to farmers and agribusiness. I've also had our Webmaster for www.doane.com put a link to a really good feature in the July 13 Wall Street Journal that focused on the bill's potential impact on farmers. It's under SPECIAL FEATURES.
Dubbed the Dodd-Frank Bill after its primary sponsors, Chris Dodd (D-Conn.) and Barney Frank (D-Mass.) the 2,300-page bill has been described by many financial writers as the most significant financial regulation since the Great Depression. Fierce critics, on the other hand, have attacked it as just the latest move by government to intrude and take over a big part of the free market. And they aren't just "conservative" critics. Indeed, even billionaire investor George Soros, known for his left-wing politics, says the bill came "too early" because banks have not recovered sufficiently to cope with the myriad of new restrictions on their activities.
The biggest target (hedge funds) escaped major change. One of the biggest concerns we've had as market analysts is that the big hedge (Index) funds might have tough new position limits thrust on them that would force aggressive liquidation of their current huge net long positions in ag futures. In wheat alone, for example, Index funds are collectively net long more than 215,000 contracts. That's equivalent to the entire projected U.S. ending stocks of more than 1 billion bushels! But the Dodd-Frank bill merely requires hedge funds with more than $150 million in assets to register with the Securities and Exchange Commission. At most, the law may fracture the hedge fund industry into a host of smaller funds with assets held under $150 million to continue "flying under SEC radar."
Smaller targets may be "collateral damage." University of Illinois economist Scott Irwin tells us he thinks the single biggest impact on farmers could be a provision that might cause a farmer (or his agribusiness suppliers or buyers) to lose their hedging exemption from position limits if they engage in a single trade deemed "speculative" under IRS rules. Just keeping your hedging account separate from a "speculative" account may not be enough.
Reform bill lowers the standards for "market manipulation." Before this bill, to charge a firm or individual with "market manipulation," the Commodity Futures Trading Commission (CFTC) had to apply a four-step test showing:
- Current prices above or below what “normal” supply and demand analysis would predict.
- The alleged "manipulator" had the ability to cause an artificial price.
- The alleged manipulator took actions that led to the artificial price.
- The alleged manipulator intended to cause a price move and not just anticipate it.
With new regs, CFTC has only to prove "reckless" trading. They no longer have to show that artificial prices have been created. They don't even have to show that an individual or firm profited from their "recklessness." They don't have to prove "intent to manipulate." Critics of this new, lower standard for proving "manipulation" through "recklessness" alone say it will be even harder to apply fairly. Some say it's reminiscent of the famous statement by Supreme Court Justice Potter Stewart in 1964 when defining hardcore pornography that was NOT protected "free speech." Stewart said, "I shall not attempt to further define materials (hardcore pornography) not protected as free speech, but I know it when I see it." Critics fear that's the tack CFTC will take when asked to define what is "reckless" trading: "We'll know it when we see it." And if so, critics say this will present traders so little guidance on what might be seen as "reckless" (with benefit of 20/20 hindsight, of course) that it will intimidate some legitimate trading, lessen market liquidity and reduce the market's value as a "price discovery" mechanism for hedging price risk by producers and users.
However, some "reckless" practices already have names in the new regulations. For example, the new law gives CFTC power to police trader practices known as "spoofing," "smashing" or "banging the close." Here are the definitions:
- "Spoofing" refers to traders entering bids or offers with the intent of cancelling just before their price is about to be accepted by another trader (executed). Purpose: To serve only as "bait" to lure other traders to those price points and enhance profit on an existing position.
- "Smashing" or "Banging the Close" refers to traders attempting to manipulate the day's settlement price by buying or selling large volumes just before the close. Purpose: Hitting or avoiding settlement prices that trigger action by others that will help or hurt an existing position.
- "The Eddie Murphy Rule"?? That's the term CFTC Chairman Gary Gensler has already given to the new regulation banning any trades resulting from use of non-public information misappropriated from a government source. (It stems from the famous 1983 Eddie Murphy movie "Trading Places" where two brothers plotted to get a government report on the orange crop harvest before release.)
Banks can't compete against their customers. They won't be allowed to use their own money to make speculative trades or trades that essentially bet against their own customers (such as farmer hedgers). And if they effectively are trading on behalf of their clients ("managed" investment services) then the bank's own trading is subject to limitations. If a bank invests its own money in a fund managed by others, they can own no more than 3 percent of any one fund and their total investment in such funds cannot exceed 3 percent of the bank's capital.
Also, the banks have to set aside more money to cover potential losses (equivalent to higher reserve requirements) and are forbidden from selling an investment to a customer and then making a separate deal in the derivatives market that is essentially betting their customer will fail. Critics say that effectively raising bank reserve requirements is counterproductive to the Obama administration's stated desire to get banks loaning more vigorously.
No more stupid loans by lenders? Most economists agree much of the financial collapse in real estate had its genesis in rules that allowed banks to make mortgage loans without regard to customer repayment ability. They would simply re-package these subprime loans and sell for a quick profit to Uncle Sam (taxpayers) via Fannie Mae. The new regs require lenders to verify any borrower's ability to repay. They are further required to give borrowers a "worst case scenario" on what their monthly payments might rise to under variable rates. And they're barred from receiving any kind of incentives to "push" borrowers into pricier loans.