March 10, 2003

Feinstein Seeks Increased Authority for CFTC and F

WASHINGTON (HedgeWorld.com)--Sen. Dianne Feinstein (D-Calif.) formally launched another effort to regulate the trading of energy derivatives.

Ms. Feinstein is the sponsor of S. 509, the Energy Market Oversight Act, introduced March 4 and immediately referred to the Agriculture Committee. The bill, cosponsored by Peter Fitzgerald (R-Ill.), Tom Harkin (D-Iowa), Richard Lugar (R-Ind.), Maria Cantwell (D-Wash.), Ron Wyden (D-Ore.) and Patrick Leahy (D-Vt.), would increase notice, reporting, bookkeeping and other transparency requirements for online and bilateral energy and metals trading and would prohibit wash sales, a practice the sponsors consider abusive. It would also require that energy companies maintain sufficient capital to cover trades, commensurate with risk.

This duplicates a bill Ms. Feinstein introduced in the last Congress, (Previous HedgeWorld Story). "It was the subject of a hearing in the Agriculture Committee," her March 4 statement said, "... but time ran out before the legislation could be approved."

In the same statement, the senator described the goals of the bill in terms of agency mandates. It "would restore the Commodity Futures Trading Commission's ... authority over online and bilateral energy trades and give the Federal Energy Regulatory Commission ... the powers it has requested to adequately investigate and punish possible instances of fraud and manipulation."

Buffett Weighs In

In what could prove to be a fortuitous bit of timing for Sen. Feinstein's bill, Warren Buffett has released the 2002 Annual Report for his investment vehicle, Berkshire Hathaway Inc., Omaha, Neb., inclusive of his customary letter. He is often outspoken in these letters, and this year it was on the topic of derivatives that he expressed himself with his usual forcefulness. He said that he and his partner, Charles Munger, regard derivatives as "time bombs, both for the parties that deal in them and the economic system."

He expressed three distinct qualms about derivatives. First, he observed that since derivatives need not be collateralized or guaranteed, their value depends upon the credit worthiness of the counterparties, he said. Second, over-the-counter derivatives need not correspond to any real market that can provide a reality check on valuation, so mark-to-market becomes mark-to-myth, in Mr. Buffett's phrasing. Third, these instruments "can exacerbate trouble that a corporation has run into for completely unrelated reasons. This pile-on effect occurs because many derivatives contracts require that a company suffering a credit downgrade immediately supply collateral to counter-parties."

He does acknowledge that derivatives have their value on what he calls a "micro-level" and says that he has made use of such derivative-based hedging himself. But, on a macro level, the picture "is dangerous and getting more so." He doesn't propose any regulation (to the contrary, he says that governments and central banks have so far found no effective way to address the problems derivatives pose), but his letter certainly will be quoted by advocates of S. 509 in the near future.

Some Skepticism

Other observers are very skeptical. Ross M. Miller, for example, president of Miller Risk Advisors, Niskayuna, N.Y., and before that the founder of the quantitative finance research group at General Electric, gives Ms. Feinstein credit for good intentions but suspects that if the bill is enacted it will create extra expense with no net benefit. "The basic problem is that anything that legislators can think of, clever traders can get around."

More specifically, "I like transparency in theory just about everywhere in the financial world. Regulators have a tough time getting it. ...The inner works of J.P. Morgan and Fannie Mae are still hidden from the market."

On capital requirements, too, Mr. Miller doubts that the consequences of such a law will be those intended. "I have found the capital requirements for banks to be laughable and don't see why those for energy companies shouldn't be, as well. Even with its various flaws, the market seems to do a good job of assessing creditworthiness."

CFaille@HedgeWorld.com

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