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"Extend & Pretend" Read the Series...

Stage 1 Comes to an End!
A Matter of National Security
A Guide to the Road Ahead 
Confirming the Flash Crash Omen
It's Either RICO Act or Control Fraud
Shifting Risk to the Innocent
Uncle Sam, You Sly Devil!
Is the US Facing a Cash Crunch?
Gaming the US Tax Payer
Manufacturing a Minsky Melt-Up
Hitting the Maturity Wall
An Accounting Driven
Market Recovery

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"UR all PIGS from HELL

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Current Thesis Advisory:

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Published November 2009

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Process of Abstraction

Research Process

1- Sovereign Debt Crisis
2- EU Banking Crisis
3 - Risk Reversal
4- State & Local Government
5 - Food Price Pressures
6 - Rising Inflation Pressures &Interest Pressures
7 - Social Unrest
8 - Chronic Unemployment
9 - China Bubble
10 - Geo-Political Event
11 - Residential Real Estate - Phase II
12 - Commercial Real Estate
13 - Public Policy Miscues
14 - Oil Price Pressures
15- Bond Bubble
16 - Pension - Entitlement Crisis
17 - Central & Eastern Europe
18 - US Banking Crisis II
19 -Credit Contraction II
20 - Japan Debt Deflation Spiral
21- Finance & Insurance Balance Sheet Write-Offs
22 - US Stock Market Valuations
23- Government Backstop Insurance
24 - Shrinking Revenue Growth Rate
25 -Global Output Gap
26 - US Dollar Weakness
27 - US Reserve Currency
28 - Public Sentiment & Confidence
29 - Slowing Retail & Consumer Sales
30 - North & South Korea
31 - US Fiscal, Trade and Account ImBalances
32 - Corporate Bankruptcies
33 - Terrorist Event
34 - Financial Crisis Programs Expiration
35 - Iran Nuclear Threat
36 - Natural Physical Disaster
37 - Pandemic / Epidemic

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"The moment of critical mass, the threshold, the boiling point"

The tipping point is the critical point in an evolving situation that leads to a new and irreversible development. The term is said to have originated in the field of epidemiology when an infectious disease reaches a point beyond any local ability to control it from spreading more widely. A tipping point is often considered to be a turning point. The term is now used in many fields. Journalists apply it to social phenomena, demographic data, and almost any change that is likely to lead to additional consequences. Marketers see it as a threshold that, once reached, will result in additional sales. In some usage, a tipping point is simply an addition or increment that in itself might not seem extraordinary but that unexpectedly is just the amount of additional change that will lead to a big effect. In the butterfly effect of chaos theory , for example, the small flap of the butterfly's wings that in time leads to unexpected and unpredictable results could be considered a tipping point. However, more often, the effects of reaching a tipping point are more immediately evident. A tipping point may simply occur because a critical mass has been reached.

The Tipping Point: How Little Things Can Make a Big Difference is a book by Malcolm Gladwell, first published by Little Brown in 2000. Gladwell defines a tipping point as "the moment of critical mass, the threshold, the boiling point." The book seeks to explain and describe the "mysterious" sociological changes that mark everyday life. As Gladwell states, "Ideas and products and messages and behaviors spread like viruses do."

The three rules of epidemics

Gladwell describes the "three rules of epidemics" (or the three "agents of change") in the tipping points of epidemics.

  • Connectors are the people who "link us up with the world ... people with a special gift for bringing the world together." They are "a handful of people with a truly extraordinary knack [... for] making friends and acquaintances". He characterizes these individuals as having social networks of over one hundred people. To illustrate, Gladwell cites the following examples: the midnight ride of Paul Revere, Milgram's experiments in the small world problem, the "Six Degrees of Kevin Bacon" trivia game, Dallas businessman Roger Horchow, and Chicagoan Lois Weisberg, a person who understands the concept of the weak tie. Gladwell attributes the social success of Connectors to "their ability to span many different worlds [... as] a function of something intrinsic to their personality, some combination of curiosity, self-confidence, sociability, and energy."
  • Mavens are "information specialists", or "people we rely upon to connect us with new information." They accumulate knowledge, especially about the marketplace, and know how to share it with others. Gladwell cites Mark Alpert as a prototypical Maven who is "almost pathologically helpful", further adding, "he can't help himself". In this vein, Alpert himself concedes, "A Maven is someone who wants to solve other people's problems, generally by solving his own". According to Gladwell, Mavens start "word-of-mouth epidemics" due to their knowledge, social skills, and ability to communicate. As Gladwell states, "Mavens are really information brokers, sharing and trading what they know".
  • Salesmen are "persuaders", charismatic people with powerful negotiation skills. They tend to have an indefinable trait that goes beyond what they say, which makes others want to agree with them. Gladwell's examples include California businessman Tom Gau and news anchor Peter Jennings, and he cites several studies about the persuasive implications of non-verbal cues, including a headphone nod study (conducted by Gary Wells of the University of Alberta and Richard Petty of the University of Missouri) and William Condon's cultural microrhythms study.









Inverted chart of 30-year Treasury yields courtesy of Doug Short and Chris Kimble. As you can see, yields are at a "support" area that's held for 17 years.

If it breaks down (i.e., yields break out) watch out!

The state budget crisis will continue next year, and it could be worse than ever. That's part of what's freaking out muni investors, who last week dumped them like they haven't in ages.

States face a $112.3 billion gap for next year, according to the Center on Budget and Policy Priorities. If the shortfall grows during the year -- as it does in most years -- FY2012 will approach the record $191 billion gap of 2010. Remember, with each successive shortfall state budgets have become more bare.

Things could be especially bad if House Republicans push through a plan to cut off non-security discretionary funding for states, opening an additional $32 billion gap. 







2011 will see the largest magnitude of US bank commercial real estate mortgage maturities on record.

2012 should be a top tick record setter for bank CRE maturities looking both backward and forward over the half decade ahead at least.

Will this be an issue for an industry that has been supporting reported earnings growth in part by reduced loan loss reserves over the recent past? In 2010, approximately $250 billion in commercial real estate mortgage maturities occurred. In the next three years we have four times that much paper coming due.

Will CRE woes, (published or unpublished) further restrain private sector credit creation ahead via the commercial banking conduit?

Wiil the regulators force the large banks to show any increase in loan impairment. Again, given the incredible political clout of the financial sector, I doubt it.

We have experienced one of the most robust corporate profit recoveries on record over the last half century. We know reported financial sector earnings are questionable at best, but the regulators will do absolutely nothing to change that.

So once again we find ourselves in a period of Fed sponsored asset appreciation. The thought, of course, being that if stock prices levitate so will consumer confidence. Which, according to Mr. Bernanke will lead to increased spending and a virtuous circle of economic growth. Oh really? The final chart below tells us consumer confidence is not driven by higher stock prices, but by job growth.


There are 3 major inflationary drivers underway.

1- Negative Real Interest Rates Worldwide - with policy makers' reluctant to let their currencies appreciate to market levels. If no-one can devalue against competing currencies then they must devalue against something else. That something is goods, services and assets.

2- Structural Shift by China- to a) Hike Real Wages, b) Slowly appreciate the Currency and c) Increase Interest Rates.

3- Ongoing Corporate Restructuring and Consolidation - placing pricing power increasingly back in the hands of companies as opposed to the consumer.


RICE: Abdolreza Abbassian, at the FAO in Rome, says the price of rice, one of the two most critical staples for global food security, remains below the peaks of 2007-08, providing breathing space for 3bn people in poor countries. Rice prices hit $1,050 a tonne in May 2008, but now trade at about $550 a tonne.

WHEAT: The cost of wheat, the other staple critical for global food security, is rising, but has not yet surpassed the highs of 2007-08. US wheat prices peaked at about $450 a tonne in early 2008. They are now trading just under $300 a tonne.

The surge in the FAO food index is principally on the back of rising costs for corn, sugar, vegetable oil and meat, which are less important than rice and wheat for food-insecure countries such as Ethiopia, Bangladesh and Haiti. At the same time, local prices in poor countries have been subdued by good harvests in Africa and Asia.


- In India, January food prices reflected a year-on-year increase of 18%t.

- Buyers must now pay 80%t more in global markets for wheat, a key commodity in the world's food supply, than they did last summer. The poor are especially hard-hit. "We will be dealing with the issue of food inflation for quite a while," analysts with Frankfurt investment firm Lupus Alpha predict.

- Within a year, the price of sugar on the world market has gone up by 25%.




Potential credit demand to meet forecast economic growth to 2020

The study forecast the global stock of loans outstanding from 2010 to 2020, assuming a consensus projection of global
economic growth at 6.3% (nominal) per annum. Three scenarios of credit growth for 2009-2020 were modelled:

• Global leverage decrease. Global credit stock would grow at 5.5% per annum, reaching US$ 196 trillion in 2020. To
meet consensus economic growth under this scenario, equity would need to grow almost twice as fast as GDP.
• Global leverage increase. Global credit stock would grow at 6.6% per annum, reaching US$ 220 trillion in 2020.
Likely deleveraging in currently overheated segments militates against this scenario.
• Flat global leverage. Global credit stock would grow at 6.3% per annum to 2020, tracking GDP growth and reaching
US$ 213 trillion in 2020 – almost double the total in 2009. This scenario, which assumes that modest
deleveraging in developed markets will be offset by credit growth in developing markets, provides the primary credit
growth forecast used in this report.

Will credit growth be sufficient to meet demand?

Rapid growth of both capital markets and bank lending will be required to meet the increased demand for credit – and it is
not assured that either has the required capacity. There are four main challenges.

Low levels of financial development in countries with rapid credit demand growth. Future coldspots may result from the
fact that the highest expected credit demand growth is among countries with relatively low levels of financial access. In
many of these countries, a high proportion of the population is unbanked, and capital markets are relatively undeveloped.

Challenges in meeting new demand for bank lending. By 2020, some US$ 28 trillion of new bank lending will be
required in Asia, excluding Japan (a 265% increase from 2009 lending volumes) – nearly US$ 19 trillion of it in China
alone. The 27 EU countries will require US$ 13 trillion in new bank lending over this period, and the US close to US$
10 trillion. Increased bank lending will grow banks’ balance sheets, and regulators are likely to impose additional capital
requirements on both new and existing assets, creating an additional global capital requirement of around US$ 9 trillion
(Exhibit vi). While large parts of this additional requirement can be satisfied by retained earnings, a significant capital gap in
the system will remain, particularly in Europe.

The need to revitalize securitization markets. Without a revitalization of securitization markets in key markets, it is doubtful
that forecast credit growth is realizable. There is potential for securitization to recover: market participants surveyed by
McKinsey in 2009 expected the securitization market to return to around 50% of its pre-crisis volume within three years.
But to rebuild investor confidence, there will need to be increased price transparency, better data on collateral pools, and
better quality ratings.

The importance of cross-border financing. Asian savers will continue to fund Western consumers and governments:
China and Japan will have large net funding surpluses in 2020 (of US$ 8.5 trillion and US$ 5.7 trillion respectively), while
the US and other Western countries will have significant funding gaps. The implication is that financial systems must
remain global for economies to obtain the required refinancing; “financial protectionism” would lock up liquidity and stifle



SocGen crafts strategy for China hard-landing

Société Générale fears China has lost control over its red-hot economy and risks lurching from boom to bust over the next year, with major ramifications for the rest of the world.

Société Générale said China's overheating may reach 'peak frenzy' in mid-2011

- The French bank has told clients to hedge against the danger of a blow-off spike in Chinese growth over coming months that will push commodity prices much higher, followed by a sudden reversal as China slams on the brakes. In a report entitled The Dragon which played with Fire, the bank's global team said China had carried out its own version of "quantitative easing", cranking up credit by 20 trillion (£1.9 trillion) or 50pc of GDP over the past two years.

- It has waited too long to drain excess stimulus. "Policy makers are already behind the curve. According to our Taylor Rule analysis, the tightening needed is about 250 basis points," said the report, by Alain Bokobza, Glenn Maguire and Wei Yao.

- The Politiburo may be tempted to put off hard decisions until the leadership transition in 2012 is safe. "The skew of risks is very much for an extended period of overheating, and therefore uncontained inflation," it said. Under the bank's "risk scenario" - a 30pc probability - inflation will hit 10pc by the summer. "This would cause tremendous pain and fuel widespread social discontent," and risks a "pernicious wage-price spiral".

- The bank said overheating may reach "peak frenzy" in mid-2011. Markets will then start to anticipate a hard-landing, which would see non-perfoming loans rise to 20pc (as in early 1990s) and a fall in bank shares of 50pc to 75pc over the following 12 months. "We think growth could slow to 5pc by early 2012, which would be a drama for China. It would be the first hard-landing since 1994 and would destabilise the global economy. It is not our central scenario, but if it happens: commodities won't like it; Asian equities won't like it; and emerging markets won't like it," said Mr Bokobza, head of global asset allocation. However, it may bring down bond yields and lead to better growth in Europe and the US, a mirror image of the recent outperformance by the BRICs (Brazil, Russia, India and China).

- Diana Choyleva from Lombard Street Research said the drop in headline inflation from 5.1pc to 4.6pc in December is meaningless because the regime has resorted to price controls on energy, water, food and other essentials. The regulators pick off those goods rising fastest. The index itself is rejigged, without disclosure. She said inflation is running at 7.6pc on a six-month annualised basis, and the sheer force of money creation will push it higher. "Until China engineers a more substantial tightening, core inflation is set to accelerate.

- The longer growth stays above trend, the worse the necessary downswing. China's violent cycle could be highly destabilising for the world." Charles Dumas, Lombard's global strategist, said the Chinese and emerging market boom may end the same way as the bubble in the 1990s. "The basic strategy of the go-go funds is wrong: they risk losing half their money like last time."

- Société Générale said runaway inflation in China will push gold higher yet, but "take profits before year end".

- The picture is more nuanced for food and industrial commodities. China accounts for 35pc of global use of base metals, 21pc of grains, and 10pc of crude oil. Prices will keep climbing under a soft-landing, a 70pc probability. A hard-landing will set off a "substantial reversal". Copper is "particularly exposed", and might slump from $9,600 a tonne to its average production cost near $4,000. Chinese real estate and energy equities will prosper under a soft-landing,

- The bank likes regional exposure through the Tokyo bourse, which is undervalued but poised to recover as Japan comes out of its deflation trap. If you fear a hard landing, avoid the whole gamut of Chinese equities. It will be clear enough by June which of these two outcomes is baked in the pie.

SocGen crafts strategy for China hard-landing Pritchard





PIMCO'S NEW NORMAL: According to PIMCO, the coiners of the term, the new normal is also explained as an environment wherein “the snapshot for ‘consensus expectations’ has shifted: from traditional bell-shaped curves – with a high likelihood mean and thin tails (indicating most economists have similar expectations) – to a much flatter distribution of outcomes with fatter tails (where opinion is divided and expectations vary considerably).” That is to say, the distribution of forecasts has become more uniform (as per Exhibit 1).

The Fed has galloped into a box canyon with no escape; no matter what it does, QE3 will "disappoint" the markets.

I think we can safely predict that "Quantitative Easing 3" (the next round of fiat money creation) will "disappoint," triggering stock and bond market mayhem. Last week I noted that the U.S. economy is now addicted via the ratchet effect to unprecedented levels of Federal borrowing and Federal Reserve fiat/credit creation and manipulation. In other words, the status quo is now completely dependent on the Federal government borrowing 40% of its expenditures ($1.5 trillion a year) and on the Federal Reserve printing fiat money and buying $1 trillion in Treasury bonds every year.

Now that Central State spending and intervention have ratcheted up to those levels, any reduction will destabilize the staus quo of zero-interest rates (ZIRP), unhindered entitlement and military/Security State spending, etc. Thus we have politicos proposing $35 billion in "cuts" to a Federal budget ( $3.8 trillion for fiscal 2011) which has leaped up by hundreds of billions of dollars in a mere decade.

1- The stock and bond markets now depend on massive injections of free money (via the Fed's POMO) into equities and the purchase of newly minted Treasury bonds.

2- Beneath the surface of illusory stability, pressures are mounting.

3- If the Fed stops buying Treasuries, then rates--already rising on the long end--will move decisively higher

4- The Fed and Treasury are now boxed in by the ratchet effect.

5- Rather than adapt and evolve, the Central State and its proxy the Federal Reserve simply moved into a higher state of vulnerability.

6- Add these factors up and predicting the Fed's next round of "Quantitative Easing" (QE3) will "disappoint" expectations is easy.

7- Political resistance to the Fed's headlong gallop into the box canyon of monetization and stock market manipulation is rising.

8- The Fed is boxed in: by expectations of continued massive intervention and by political pressure to cease or curtail these very same interventions.

Ironically, if the Fed flouts political pressure and ramps up its manipulations via a monumental QE3 program, that may well disrupt the markets as much as a policy of diminished intervention, for the markets would soon grasp that the Fed would be guaranteeing a political firestorm of resistance if the Fed's manipulations didn't spark a hiring/jobs boom by the 2012 election season. And we all know the Fed's QE3 will not spark a hiring boom, for the Fed's policies are designed to serve one goal: preserve and enrich the financial sector's Elites. Now that they're safely in the lifeboats, the failure of the Fed's policies to "trickle down" to the steerage passengers is increasingly evident.

Recapitalizing the "too big to fail" banks has not yet been accomplished, despite the Fed's gargantuan channeling of national income into Wall Street and the TBTF banks. So the Fed is triply boxed in: its unprecedented efforts to recapitalize the TBTF banks and restore Wall Street's swollen profits are only partially complete, yet it is already encountering stiff political resistance. Even worse, the interventions have had to be ratcheted up to maintain their effect, akin to an addiction or insulin resistance.

The vulnerabilities have not been erased, they've only been masked. The pressures on the financial faults beneath our feet are increasing, and the tremors will soon give way to sudden dislocations of expectations, risk and price.

The United Nations reckons countries spent at least $1 trillion on food imports in 2010, with the poorest paying as much as 20 percent more than in 2009. These increases are just getting started. In January, world food prices rose to another record on higher dairy, sugar and grain costs.

This crisis might lead to another: debt. Expect Asian leaders to increase subsidies sharply and cut import taxes. The fiscal implications of these steps aren’t getting the attention they deserve. The same is true of social-instability risks. Events in Egypt are a graphic example of how people living close to the edge can get motivated in a hurry to demand change. Keeping that rage bottled in the age of Twitter, YouTube and Facebook won’t be easy.

The Westernization of Asia’s diet is partly behind the rise in food costs. Rapid growth, rising incomes, growing populations and urbanization are conspiring to shift eating habits away from the staples of old toward livestock and dairy products. Asia alone, for example, will have another 140 million mouths to feed over the next four years. Add that to almost 3 billion people in the fast-growing region and you have a recipe for booming demand.

China’s size and scope means it will be buying up ever- growing chunks of the world’s food supply. As the yuan rises, so will China’s ability to outbid everyone else. Increased trade tensions are inevitable and it will show the futility of food subsidies. Prices will rise as long as consumption does, so it’s really a matter of pouring money down the drain.

Rising food prices will complicate things for China’s central bank. That goes, too, for India, Indonesia, the Philippines and even less developed economies from Pakistan to Vietnam. This will be an inconvenient reality check for Asia bulls. Take Indonesia, the fourth-most populous nation and home to the biggest Muslim population. Food prices make it harder to deliver higher living standards and narrow the gap between rich and poor. The same goes for other countries in which population growth often outpaces gross domestic product, like the Philippines.

What’s killing households surviving on a few dollars a day is price volatility. If you spend almost half of your income to fill bellies, a 10 percent surge in cooking oil, wheat or chili peppers is devastating. It’s hard enough to pay rent and handle health-care costs today, never mind investing in education.

So big are the increases that economists are buzzing about them pushing deflationary Japan toward inflation. Yes, rising costs for commodities such as wheat, corn and coffee might do what trillions of dollars of central-bank liquidity couldn’t.

Yet the economic consequences of food prices pale in comparison with the social ones. Nowhere could the fallout be greater than Asia, where a critical mass of those living on less than $2 a day reside. It might have major implications for Asia’s debt outlook. It may have even bigger ones for leaders hoping to keep the peace and avoid mass protests.

What a difference a few months can make. Back in, say, October, the chatter was about Asia’s invulnerability to Wall Street’s woes. Now, governments in Jakarta, Manila and New Delhi are grappling with their own subprime crisis of sorts. This one reflects a toxic mix of suboptimal food stocks, exploding demand, wacky weather and zero interest rates around the globe.

It’s not hyperbole when Nouriel Roubini, the New York University economist who predicted the U.S. financial crisis, says surging food and energy costs are stoking emerging-market inflation that’s serious enough to topple governments. Hosni Mubarak over in Egypt can attest to that.

Last week, the S&P 500 Index ascended to a Shiller P/E in excess of 24 (this "cyclically-adjusted P/E" or CAPE represents the ratio of the S&P 500 to 10-year average earnings, adjusted for inflation). Prior to the mid-1990's market bubble, a multiple in excess of 24 for the CAPE was briefly seen only once, between August and early-October 1929. Of course, we observed richer multiples at the heights of the late-1990's bubble, when investors got ahead of themselves in response to the introduction of transformative technologies such as the internet. After a market slide of more than 50%, investors again pushed the Shiller multiple beyond 24 during the housing bubble and cash-out financing free-for-all that ended in the recent mortgage collapse.

And here we are again. This is not to say that we can rule out yet higher valuations, but with no transformative technologies driving the economy, little expansion in capital investment, and ongoing retrenchment in consumer balance sheets, I can't help but think that the "virtuous cycle" rhetoric of Ben Bernanke is an awfully thin gruel by comparison. We should not deserve to be called "investors" if we fail to recognize that valuations are richer today than at any point in history, save for the few months before the 1929 crash, and a bubble period that has been rewarded by zero total return for the S&P 500 since 2000. Indeed, the stock market has lagged the return on low-yielding Treasury bills since August 1998. I am not sure that even members of my own profession have learned anything from this.

Based on our standard methodology (elaborated in numerous prior weekly comments), we presently estimate that the S&P 500 is priced to achieve an average total return over the coming decade of just 3.15% annually. Again, we've seen weaker projected returns over the past decade. But then again, the S&P 500 lost about 5% annually in the decade following the 2000 peak, and even including the recent advance, has achieved an annual total return since 2000 of almost exactly zero. So despite periodic speculative runs, rich valuations have an annoying way of ruining the fun. Equally important, even during extended speculative periods as we observed in the late-1990's, those advances have tended to suffer deep and abrupt intermediate-term corrections once elevated valuations are joined by overbought conditions, overbullish sentiment, and rising interest rates, as we observe today.

While we can certainly find analysts who believe stocks are cheap, we can easily test the long-term accuracy of their methods (which often amount to nothing more than applying an arbitrary multiple to forward operating earnings, or dividing the forward earnings yield by the 10-year Treasury yield). Frankly, many of those alternative methods stink. Regardless of whether an analyst claims that stocks are cheap or expensive, they should be expected to provide some sort of evidence that their methods have a strong relationship with subsequent market returns.

Upwards of 130,000 jobs could be lost if U.S. regulators impose new restrictions on derivatives transactions too broadly, according to a study to be released Monday.

Commissioned by several major business groups, the study estimates that if regulators require all S&P 500 companies to put up 3% cash collateral on every over-the-counter derivative trade, with no exceptions, the move could collectively reduce capital spending among those firms by $5.1 billion to $6.7 billion per year. The analysis is based on the responses from 74 firms, 30% of which are members of the S&P 500. That composition of respondents makes the results a good approximation of the total population of large-cap, public American companies, said Keybridge Research, the consulting firm that performed the analysis. ( Read the full report.)

The report is part of an intensifying effort by U.S. corporations to push back against regulators, particularly Commodity Futures Trading Commission chief Gary Gensler, as they write the rules that will implement a tough new regulatory regime on the $600 trillion derivatives market that is part of the Dodd-Frank financial-overhaul law. These companies, so-called corporate end users of derivatives, use these financial contracts to hedge against day-to-day business risks such as fluctuations in interest rates or fuel prices. The report was commissioned by the Coalition for Derivatives End Users, an umbrella group of trade associations including the Business Roundtable and the U.S. Chamber of Commerce.

End users lobbied hard to win exemptions from new requirements placed on derivatives trades as Congress wrote the Dodd-Frank financial-overhaul law. But last-minute changes muddied the law’s language, particularly on the question as to whether end users broadly would be exempt from a new requirement to post margin on over-the-counter derivatives, these businesses say. They complain that Mr. Gensler, whose agency has a lead role in writing the margin rules, won’t give them a clear signal as to how his agency will interpret the ambiguous language.

Among the findings that the coalition hopes will influence regulators rule-writing:

*46% of the firms would look into doing their derivatives business in another country as a result of the new derivatives rules.

*Most (91%) of firms said that higher margin and capital costs placed on their counterparties would likely increase transaction costs for them as well. As a result, 68%, said they would likely reduce hedging, 41% said they would increase pricing to end customers and 23% would shift risk to customers or suppliers.

The results show that there is “no upside” to imposing margin requirements on end users, said David Hirschmann, who heads the U.S. Chamber’s Center for Capital Markets Competitiveness.

Companies increase their exposure to risk by decreasing their hedging, moving their trading business outside of the United States or tying up their capital by posting collateral on derivatives are all bad outcomes, he said. From an economic perspective “It’s lose, lose, lose,” he said.

In addition to sending the results to financial regulators, the coalition also plans to share the study with their allies on Capitol Hill, many of who are already agitated over the issue. Earlier this month, a bipartisan group of 13 senators led by Sen. Mike Johanns (R., Neb.) sent a letter to regulators warning them to preserve congressional intent and not apply margin requirements to end users’ over-the-counter derivatives. “Imposing margin requirements on those who engage in the hedging of legitimate business risks would not only blatantly disregard the end-user exemption and Congressional intent, but it could also have the effect of draining scarce working capital from the balance sheets of mainstream American companies. Regulators must be cautious to prevent such a result, as it could stunt needed economic growth and produce higher costs for consumers,” the senators wrote.

Mr. Gensler faced sharp questioning from several lawmakers at a House hearing last week. “There are growing concerns among end-users that they may be subject to margin requirements for their over-the-counter trades – an outcome that is clearly inconsistent with congressional intent,” Rep. Frank Lucas (R., Okla.), the new chairman of the House Agriculture Committee, said before Mr. Gensler testified. “A margin requirement imposed upon end-users would subject them to significant cash burdens, cash that would otherwise be put to work in the economy. At the same time, such a requirement will create a significant disincentive to responsible risk management practices that provide price certainty and stability, and allow companies to remain focused on their core businesses.”

Mr. Gensler said at the hearing that he expects the CFTC to address the margin rules in March. The coalition’s survey was conducted between Nov. 3 and Jan 7. In total, about 250 companies were contacted and 74 provided responses. Of those, 72 firms said they use over-the-counter derivatives. The responding companies represent $1.03 trillion in revenues, or about 8% of U.S. gross domestic product, and employ more than 2 million people. Sixty-six also provided more detailed data on their derivatives exposure. For these companies, the total gross notional amount was $422.2 billion, or $6.4 billion per company.

The study found that for those 66 firms, a 3% margin requirement would result in aggregate collateral of $12.7 billion, or an average of $191.9 million per firm, or roughly 1% of revenue.

Other interesting details turned up by the survey included the fact that interest-rate risk topped the reasons for firms to use derivatives. The firms reported using 62% of their derivatives to manage interest rate risk; 27% to hedge foreign currencies; and 16% to hedge commodity prices. Also half of the firms surveyed were so uncertain about what the final rules and their impact will be that they’re not sure if they will disclose the impact of Dodd-Frank on their financial statements.


John Parsons, a senior lecturer at MIT’s Sloan School of Management, critiques the Coalition’s study on his blog “Betting the Business.” The major flaw he says is that the study assumes that the 3% collateral requirement is “a deadweight cash flow cost to the companies.”

Mr. Parsons argues that’s wrong on both a micro and macro level.

“The micro mistake is the delusion that absent a collateral requirement companies are able to trade derivatives at no cost to their balance sheet. This is plainly not true,” he writes. “If you don’t back up your derivative trades with a cash collateral account, then you are backing them up with a promise that you are good for it, i.e. with credit. Companies have limited debt capacity, so using credit is costly, too. A regulation that requires using cash instead of credit costs the company on one side, but loosens its constraints on the other. The net effect on the company’s free cash flow is zero.”

The study’s macro mistake is that it ignores the possibility that the regulation will reduce “total risk in the system.” He writes: “[T]he only sensible way to examine the net impact of the regulations is to think through the full systemwide impact. One can have a good debate about whether or not the Dodd-Frank reforms will reduce the total risk in the system, and about what contribution a collateral requirement may make. But simply ignoring the systemwide impacts is not a useful contribution to reasoned debate on the matter.”