Risk & Compliance

DOA: Derivatives Oversight Agency

Troubles at Freddie Mac trigger calls for a derivatives regulatory body. Overkill? Plus: more confusion over cash-balance pension plans.
Marie LeoneJune 16, 2003

The shakeup at Freddie Mac” last week underscored a problem that many observers say should have been resolved in 1994: derivatives remain a risky — and unregulated — financial instrument.

Certainly, over the past ten years, the U.S. financial landscape has been littered with the broken remains of derivatives schemes gone wrong. As The New York Times recounts it, in 1994, Proctor & Gamble lost $102 million on derivatives contracts designed by Bankers Trust. Then in 1998, hedge-fund Long-Term Capital Management collapsed under the weight of derivatives that put a portfolio of $1.25 trillion at risk. By 2001, Enron Corp. was caught using derivatives to bury $3.9 billion in debt.

Then, just a few days ago, federal prosecutors announced a formal investigation into derivatives accounting at Freddie Mac, the nation’s second-largest packager of mortgage obligations. Freddie Mac uses swaps and related derivatives to manage the interest-rate risk on its huge loan portfolio.

Some observers claim new rules would help companies avoid devastating missteps. But new regulation has been thwarted by warring factions that argue about how to price and account for derivatives — and what is the proper level of disclosure for the synthetics.

The real danger to corporate users, says a report in The New York Times, is the knowledge gap about the instruments. Indeed, the Times claims that few CEOs and CFOs truly understand the derivatives that are currently in use at their companies.

Stephen Mader, CEO of search firm Christian & Timbers told The Times that only one in 10 CEOs have any in-depth knowledge of the sophisticated financial instruments.

Meanwhile, Roman L. Weil, a professor of accounting at the University of Chicago, thinks that most finance chiefs are “only vaguely aware of the accounting rules,” for synthetics. That’s because most CFOs come out of the treasury operation — not the controller function — Weil asserts.

Observers also point out that keeping up with derivatives accounting can be a full-time job in itself. FAS 133, which explains the proper accounting treatment for derivatives, has grown as complex as the instruments it governs.

As for relying on regulation to protect corporate users, don’t hold your breath. Discussion apparently outstrips action. For instance, three days after the Freddie Mac story broke, the Senate defeated a bill that would have regulated online trading of energy derivatives — the trading space where Enron executives ran amok.

The amendment, sponsored by Dianne Feinstein (D-Calif.), was described as a measure to close “the Enron loophole.” Essentially, the bill attempted to override the Commodity Futures Modernization Act of 2000 — legislation that exempted energy trading from regulation. According to a report in The Oil Daily representatives of Enron had lobbied heavily for the exemption.

In fact, regulating derivatives has always been an uphill battle. When the Federal Reserve bailed out Long-Term Capital in 1998, Brooksley Born, then head of the CFTC, recommended regulating parts of the derivatives market. She was rebuffed by traders and regulators, reports The Times.

The Freddie Mac imbroglio may still trigger some regulatory action, however. Lynn Turner, a professor at Colorado State University and a former chief accountant with the SEC thinks that the Freddie Mac mess will likely prompt more oversight from federal regulators. In an interview with CNBC, Turner said he expects that Freddie Mac, a government-sponsored entity, will become subject to the same SEC regulations that public companies have to operate under.

He also believes that the capital markets will demand more financial information from Freddie Mac — and its corporate cousin Fannie Mae. At the end of 2001, the two quasi-corporations were holding about $1.4 trillion in outstanding interest rate derivatives.

The scandal at Freddie Mac has also pushed John Damgard, president of the Futures Industry Association, to call for the creation of a watchdog for the entire futures and options industry. During the International Derivatives Conference in London last week, Damgard told Reuters that an increase in regulatory safeguards was necessary. “There remains a need for more effective regulations,” he said.

Others at the conference favored a more conservative approach. For example, John Mathias, director of financial futures and options at Merrill Lynch International, is against a new derivatives regulatory body. He’d rather see a better link between the existing watchdogs: the Commodities & Futures Trading Commission and the SEC.

But one unnamed broker-dealer told Reuters he’d like to see the industry get tough with regulators. His suggestion: a two-year deadline imposed on CFTC and the SEC to start working together — or run the risk of being usurped by a new regulatory body.

Pensions: Cash-balance Barriers

When the Treasury Department and the Internal Revenue Service released proposed regulations last year that would make it easier for corporates to convert to cash-balance pension plans, plan sponsors applauded the move. Having now read the fine print, some are less enthused.

The new rules, it turns out, could actually make it harder to switch to such plans. While Treasury has since scrapped one of the problematic regulations, experts say unintended barriers to cash-balance plans still lurk in the remaining rules.

The proposed rules were intended to clear up ambiguity around age discrimination in pension plans. But critics soon pointed out that the rules would render illegal a number of current pension plan practices — even some that are considered friendly to older workers.

Most of the controversy centers on changes to the so-called comparability rule. The American Benefits Council (ABC), which represents large corporate plan sponsors, believes that changes to the rule, intended to prohibit benefits plans from being weighted in favor of highly compensated employees, might also block other, more praiseworthy practices. One of those practices: offering “transition credits” to older workers whose benefits would be diminished if an employer switches from a defined-benefit to a cash-balance plan. The rule change could also prohibit grandfathering older employees into an existing pension plan.

The proposed regulations would have prevented these practices because older employees are often more highly compensated than others, thanks to their generally longer tenure. “Plans that employed such practices were virtually an automatic fail under the proposed rules,” says Eric Lofgren, director of benefits consulting at Watson Wyatt.

After receiving nearly 5,000 comment letters on the proposed regulations, the Treasury Department announced on April 7 that it was withdrawing the new comparability rule. That’s good news for companies that want to convert to cash-balance plans. But it may not be the end of the debate.

Another provision in the proposed regulations, an age-discrimination test for pension plans, would apparently have the side effect of prohibiting long-standing pension practices. “They’ve proposed a quantitative age-discrimination test that’s unworkable,” charges John Scott, director of retirement policy at the ABC. “Perhaps they created more problems than they solved.”

Critics of cash-balance plans aren’t happy with the regulations, either. Eva T. Cantarella, an attorney at Hertz, Schram & Saretsky, in Bloomfield Hills, Mich., says she doesn’t believe the regulations are helpful to the age-discrimination debate. “I don’t think all these proposed regulations are necessary,” she says.