In 1901, 40 percent of a consumer’s income was spent on food consumed at home. By 2001, that number had dropped dramatically to 7.8 percent. As a result of the low cost of food, more of a family’s income can be spent on housing, transportation and health care. In this economic climate, when many families are affected by unemployment, the consistent low cost of food is more important than ever in order to stretch each dollar as far as possible. While it may not be apparent at the supermarket, complex financial products called derivatives play an essential role in avoiding significant price spikes in your groceries. Unfortunately, new regulations being considered in Congress may threaten the ability of businesses to utilize these products to help consumers.
Far from being insidious “weapons of mass destruction”, derivative products are important innovations for companies looking to stabilize prices of materials and resources and appropriately manage their risk. A derivative allows the underlying risk of an asset to be traded between two parties as a financial product. In the instance of the grocery store, farmers and food companies can use derivatives to hedge against the risk that a weather event such as a drought, excess rain or a widespread freeze will result in crop losses. This reduction in risk helps avoid price spikes in food for consumers.
The 2001 crop yield of barley in Carrington, N.D., provides an illustrative example of how farmers can positively employ derivatives. Unlike most bulk cereals, the uses for barley are heavily dependent upon its quality. Beer manufacturers pay a premium for the high quality of barley they need for their product. If the quality is insufficient for use in beer, barley can be used for animal feed, but as a result it sells at a much lower price. As the barley crop matures and nears harvest, excessive rain and humidity can create weight problems for the crop and damage the color. In 2001, a derivative product known as the “barley hedge” was created to manage the risk tied to this sensitive crop. Under the terms of the derivative contract, the occurrence of nine rain “events”—defined as three consecutive days with precipitation equal to or greater than 0.35 inches—would trigger a payment of $0.65 per bushel to barley farmers using the derivative. The contract was sold to farmers for $0.12 a bushel, and yielded a $0.53-per-bushel gain for the farmer on payout. That summer, this hedge did pay off due to excess rain at the specific location in which this derivatives product was used. Barley is just one example; numerous agricultural products such as cotton, tobacco and vegetables can experience deficiencies in crop quality due to excessive rain.
Unfortunately, products that hedge a unique business risk, such as the barley hedge, are under attack as Washington seeks to reform our banking sector. Rather than develop a sophisticated understanding of how these products are used, many politicians seek to demonize them for being complex. Some go so far as to blame them for the recent economic collapse. In reality, derivatives played a limited role in the financial crisis, and the knee-jerk reaction to apply bank-like regulations to non-bank market participants threatens to create serious harm not only to financial markets but more importantly to thousands of non-financial companies using derivatives products—companies that America needs to create economic growth.
One prominent myth that persists is the idea that the failure of the investment bank Lehman Brothers caused the panic at the insurance corporation American International Group (AIG) because of the number of derivatives contacts that AIG had with Lehman. In reality, in the month following Lehman’s bankruptcy, its derivatives contracts were settled and AIG lost very little as a result of its Lehman exposure. Additionally, after its bailout of AIG, the Federal Reserve issued a statement clarifying its reasoning, highlighting “market fragility” as its cause for intervention, not derivatives exposure. AIG’s failing health was ultimately attributed to the company’s failure to appropriately assess the risks of its portfolios of mortgage-backed securities (MBS) and collateralized debt obligations (CDOs).
As we explore additional solutions to the financial crisis, we must acknowledge and explore the deficiencies of these regulations that oversee our country’s banking industry. We must also acknowledge the wide array of options available to consider, such as the one offered by House Republicans, which establishes an over-the-counter trade repository that provides transparency to the derivatives marketplace. The goal of financial services regulatory reform must be to achieve financial stability. This process should not be viewed as an opportunity to restrict innovation or exact punitive regulations on financial products that did not cause the crisis.
Rep. Scott Garrett represents New Jersey’s 5th district and is the Ranking Member on the Subcommittee on Capital Markets, Insurance, and Government-Sponsored Enterprises for the House Financial Services Committee