The Dodd-Frank Act that in a mere 2,000 pages sought to put the control back in financial regulation skipped right over Fannie Mae and Freddie Mac the Government Sponsored Enterprises that were at the heart of the fiscal crisis and are bleeding red ink. Focusing instead on those evil bankers on Wall Street the Dodd-Frank Act really put those guys in a box, until Goldman Sachs slipped its fetters faster than Houdini. So who’s buried under the pile of rubble that is the latest masterpiece of our massive government, Betsy Jensen. Who is Betsy Jensen?
Betsy Jensen is a farmer in southwest Minnesota. She and her family grow wheat and soy beans. She doesn’t have a mortgage, so she didn’t cause the housing bubble. But she does use derivatives to control the risk in farm prices which can be rather volatile. For example, a bushel of wheat went for $18.69 in February of 2008 whereas it was selling for $3.49 in July of 2010. A farmer has to buy their seed and fertilizer at the beginning of the growing season and they don’t sell their product until the harvest. If prices fluctuate wildly during that interval, it isn’t hard to imagine what that can do to your business, let alone your sleep patterns.
So where do derivatives come in? Farmers like Betsy can negotiate a guaranteed price for their grain with their customers. Betsy risks missing out on some profits if the prices go up as they have recently (45%) due to fires in the wheat producing region of Russia, but she also is protected against a price drop, for similar reasons beyond her control. She recently negotiated a price of $7.15 per bushel and with that knowledge, she can manage her farm business and sleep a little more peacefully. For her purchases she can also use derivatives to buy fuel and fertilizer, where the latter has seen price fluctuations of $435 to $685 per ton. Then along come Barney Frank and Chris Dodd, a couple of career politicians who never worked in the private sector.
The Dodd-Frank Act says it is unlawful to enter into swaps (derivatives) “in excess of such amount as shall be fixed from time to time” by the Commodities Futures Trading Corporation (CFTC). That doesn’t sound like a free market to me. What if, in Betsy’s example, the CFTC didn’t get around to raising the amount on wheat above $5 per bushel? Betsy couldn’t arrange to sell it for $7.15. What if the grain elevator couldn’t turn around and sell Betsy’s wheat for the 45% increase in price due to the Russian fires? Do you think with a cap on the upside they might not be willing to pay as much for Betsy’s wheat?
From Dodd-Frank to Bill O’Reilly we hear about the evils of speculators. O’Reilly used to rail against the speculators when gas prices were rising toward $5 per gallon. The evil, greedy speculators were driving up the price of gas! But little mention was made of speculators when the price of gasoline fell back down? Did the speculators retire? Go on vacation? The reality is that speculators don’t care if the price goes up or down, they only care it moves in the same direction on which they are betting. They can drive the price down just as fast as they can drive it up. But they are useful, not evil.
Speculators bring liquidity, that is, money to the market. Betsy Jensen estimates that about one-third of the purchasers of wheat contracts are traders who never take physical control of the product. But by adding their view and their money to the market they keep prices from fluctuating wildly. If these traders are banned then, as she put it, one-third of her customers would disappear. With one-third fewer customers the price swings will increase rather than decrease. Remember, a trader who does not take delivery of the wheat can make money on small swings in the price and is likely to get in or get out on smaller moves and thus change the market price accordingly. If only those who take physical possession of the product are in the market, then other factors such as transport, storage, spoilage, must be factored into each transaction and the price swings will be wider and wilder.
But Betsy said it best, “I may not be able to manage Mother Nature, but I can manage my risk with derivatives.” If only our government would get out of her way and let her do so.
