Why Corporate America Opposes Derivatives Reform

Lawmakers who support strict derivatives measures may want to consider the airline industry in 2008, the year that oil prices touched $150 a barrel.
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NEW YORK (

TheStreet

) -- Lawmakers who support strict derivatives measures may want to consider the airline industry in 2008, the year that oil prices touched $150 a barrel.

The global industry lost more than $10 billion. U.S. carriers accounted for roughly half of those net after-tax losses, according to the International Air Transport Association. Ticket prices soared, carriers started charging for bags and food and people cut back on flying.

Bucking the trend,

Southwest Airlines

(LUV) - Get Report

earned $178 million. It paid an average of $2.44 per gallon of fuel, roughly half the cost that competitors faced. It didn't add any service fees, and the average passenger fare was $119, a relatively small increase of 12% from $107 the previous year. Southwest's traffic rose, and its "load factor," which measures how full a plane is, fell just 1.4 percentage points to 71.2%, while other carriers grounded planes due to weak demand.

How was Southwest able to pull this off? Derivatives.

In a prescient move, the Dallas-based carrier

locked in agreements years earlier

when it thought fuel prices were artificially cheap, and poised to surge.

Airlines have been using fuel-hedging derivatives like swaps, options and futures to offset the risk of commodity-price fluctuations since the late 1980s. Carriers can effectively lock in a maximum cost ahead of time by betting on the direction of prices. In simple terms, let's say Airline X has $1 million in notional bets that oil will be trading at $50 per barrel a year from now, based on a fuel-price index. If oil is trading at $42 a barrel, the airline has to pay $8 per barrel to its counterparty who bet against it. If oil is trading at $55 per barrel, the counterparty has to pay the airline.

Ultimately, these trades tend to cancel one another out with a marginal difference, but they affect the risk-averse psychology of corporate America and can have a significant impact on the bottom line. Southwest is just one example, but it's difficult to find a major company that doesn't use some kind of derivative:

94% of companies across the globe have exposure to the lightly regulated industry, according to International Swaps and Derivatives Association.

The derivatives issue has come to the fore for corporate America, because Congress is trying to rein it in. A recent add-on to the broader financial reform proposal by Sen. Blanche Lincoln (D., Ark.) has them particularly worried. Her measure would force banks to house their derivatives business separately from the bank holding company, which is protected by the U.S. government.

As a result, banks would either have to capitalize their derivatives arms -- likely by raising funds from end-users -- spin them off or wind them down entirely. In any case, the business of derivatives is probably going to get more costly for end-users. The Chamber of Commerce, National Association of Manufacturers and other large commercial trade groups have been fighting to minimize the impact. But if the Lincoln amendment succeeds, it appears they're in for a bumpy ride.

"The government has no idea that the use of derivatives may keep the price of flour down," Rochdale Securities analyst Dick Bove said in a note last week. "They may keep the cost of an airline flight lower than otherwise would be the case. They keep interest rates in check on loans. They facilitate foreign commerce. None of this is understood. None of this has been discussed in the unremitting attacks on the industry."

Derivatives extend beyond Wall Street and beyond the airline industry. The health care giant

Pfizer

(PFE) - Get Report

uses them to protect against interest rate and currency swings. So does farm-equipment maker

Caterpillar

(CAT) - Get Report

and other household names like

Kraft

(KFT)

, for commodities and foreign exchange.

These corporate goliaths may not have heavy involvement in the alphabet soup of CDOs, CLOs, SIVs and CDSs that took down Lehman Brothers, Merrill Lynch and American International Group. Instead, they use swaps, futures, options, forex contracts and forwards to manage risk and focus on running the business instead of worrying about where the market is headed. Nonetheless, Lincoln's bill could have sweeping effects on how all derivatives are handled and how much it costs to participate in the market.

The broader reform measure structured by Senate Banking Committee Chairman Chris Dodd, or the other one approved by the House last year, are less stringent. Dodd's bill would mandate clearing, margins and capital requirements -- all of which will have serious impacts on derivatives trading but wouldn't threaten to extinguish it in the U.S. in quite the same manner.

The rhetoric in Congress could have a serious impact on the way U.S. industry manages risk. For instance,

Goldman Sachs

(GS) - Get Report

executives were recently grilled by a congressional committee about a questionable derivatives deal structured in 2007. Sen. Claire McCaskill (D., Mo.) was one of the loudest critics, comparing Wall Street traders to a "pit boss in Las Vegas" and calling the type of derivative in question "the la-la land of ledger entries."

"It's not investment in a business that has a good idea. It's not assisting local governments in building infrastructure," she said. "It's gambling, pure and simple raw gambling."

McCaskill may have a point as it pertains to the synthetic collateralized debt obligation that Goldman structured and effectively bet against, as certain clients lost over $1 billion on the trade. But the first well-known derivative deal didn't even occur on Wall Street; it happened in Washington, D.C. It involved

IBM

(IBM) - Get Report

and the World Bank, and was a swap of funds from Zurich and Berlin that transpired between the capital and Armonk, N.Y. And it didn't involve any casinos; it simply allowed the technology giant to keep its borrowing costs down.

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Written by Lauren Tara LaCapra in New York