An Analysis f the Business Rundtable s Survey n Over-the-Cunter Derivatives Prepared Fr: Business Rundtable Prepared Fr: Keybridge Research April 14, 2010 K E Y B R I D G E R E S E A R C H LLC 3050 K S T R E E T N W, S U I T E 2 2 0 W A S H I N G T O N DC 2 0 0 0 7 2 0 2. 9 6 5. 9 4 8 0 K E Y B R I D G E R E S E A R C H. COM
I. Intrductin One aspect f financial regulatry refrm deals with the unregulated ver-the-cunter (OTC) derivatives market. Several versins f prpsed legislatin 1 wuld impse a series f new regulatins n transactins executed in the OTC derivatives market. Amng ther significant changes, the prpsed regulatins intend t subject dealers and Majr Swap Participants t capital and margin requirements n cleared and un-cleared transactins. Althugh exemptins may apply fr certain nn-financial firms, there remains sme ambiguity ver the extent f these ptential exemptins. II. Survey Descriptin In respnse t the current debate n OTC derivatives regulatin, Business Rundtable ( BRT ) recently cnducted a survey n the usage f OTC derivatives t gauge the ptential effects f prpsed legislatin, including a margin requirement. The Derivatives Survey was in the field in the winter and spring f 2010. Of the 169 member CEOs n the Business Rundtable, 43 participated in the survey a respnse rate f 25%. Of these 43 cmpanies, 39 reprted the use f OTC derivatives, and 27 nn-financial firms prvided data n the ntinal amunts f their OTC derivatives expsure. Frm a statistical pint f view, 27 respnses ffers a basic level f statistical supprt fr viewing the results frm these cmpanies as an apprximatin f the ttal ppulatin f BRT cmpanies. III. Key Findings Rughly 72% f survey participants reprt that prpsed regulatins wuld have a significant impact n their hedging activities; 26% say that new legislatin wuld have a mderate impact; and nly 3% say the new rule wuld have n impact. A 3% margin requirement, assuming n exemptins, wuld result in aggregate cllateral f $33.1 billin fr nn-financial, publicly traded BRT cmpanies. On average this wuld be equal t $269 millin per firm (median: $105 millin), r rughly 15% f cash n the balance sheet (median: 7%) and 5.5% f perating cash flw (median: 4.8%). On a cumulative basis, nn-financial, publicly traded BRT cmpanies wuld be likely t respnd t the impsitin f margin requirements n OTC derivatives by reducing capital spending by -0.9% t -1.1%, r abut $2.0 t $2.5 billin, assuming n exemptins. Extending the analysis t the S&P 500 cmpanies, this nte estimates that a 3% margin requirement n OTC derivatives culd be expected t reduce capital spending by $5 t $6 billin per year, leading t a lss f 100,000 t 120,000 jbs, including bth direct and indirect effects. 1 Senatr Ddd s (D-Cnn.) recently released financial refrm prpsal, the U.S. Huse f Representatives' "Wall Street Refrm and Cnsumer Prtectin Act f 2009" passed last December, and the Obama Administratin's financial regulatry framewrk intrduced by the U.S. Treasury last summer. 2
IV. Detailed Findings Mre than 90% (39/43) f survey participants reprt the use f derivatives. The respnding cmpanies represent $1.5 trillin in revenues (equivalent t mre than 10 percent f U.S. natinal GDP) and 2.5 millin emplyees (as f 12/31/2008). 34 BRT cmpanies reprted OTC derivatives expsure as f 9/30/2009. The cmbined markt-market value was $7.2 billin and the ttal ntinal value was $660.6 billin. The median OTC derivatives expsure was $2.9 billin per firm (ntinal value). 27 f these survey participants are nn-financial firms, f which the ttal ntinal value f OTC derivatives was $508 billin as f 9/30/2009. The median expsure was $2.9 billin in ntinal value. Amng nn-financial BRT cmpanies, as f 9/30/2009, the median rati f OTC derivatives (ntinal value) t ttal assets was rughly 18% and the median rati f OTC derivatives (ntinal value) t cash was rughly 246%. 47% f BRT cmpanies reprt freign currency expsure as the tp risk hedged with OTC derivatives, fllwed by interest rate risk (32%) and cmmdity price risk (16%). Similarly, survey participants reprt that, n average, 41% f derivatives are used fr hedging freign currencies, 36% t manage interest rate risks, and 17% t hedge cmmdity prices. Over the past tw years, excluding the effect f hedges, survey participants csts assciated with price mvements f freign currencies, interest rates, and cmmdities have increased, n average, by $273 millin, $209 millin and $390 millin, respectively. Amng nn-financial survey respndents, 83% f all derivatives used are OTC, 89% are GAAP-cmpliant, and nly 23% f firms use credit default swaps. 47% f BRT cmpanies reprt freign currencies as the tp risk hedged with OTC derivatives, fllwed by interest rates (32%) and cmmdities (16%). Tp Three Risks Hedged With OTC Derivatives 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% Cmmd., 16% Cmmd., 16% Cmmd., 11% Int Rates, 26% Int Rates, 32% Int Rates, 31% Frex, 47% Frex, 47% Frex, 56% Greatest Risk Secnd Greatest Risk Third Greatest Risk 3
Nearly 3 ut f 4 (72%) survey participants say that prpsed regulatins wuld have a significant impact n their business; 26% say that new legislatin wuld have a mderate impact; and nly 3% say the new rule wuld have n impact. Impact f Margin Requirements n Hedging Activities N impact, 3% Mderate impact, 26% Significant impact, 72% V. Financial & Ecnmic Implicatins Prpsed legislatin requiring 3% cash cllateral n OTC derivatives culd result in a significant diversin f cash flw frm nrmal perating and investment activities. The analysis perfrmed by Keybridge Research, belw, prvides a rugh estimate f the ptential impact f a 3% margin requirement n all OTC derivatives t Business Rundtable nn-financial, publicly traded cmpanies. The analysis assumes n exclusins frm the margin requirement. The analysis fllws the fllwing methdlgy applied t nn-financial, publicly traded Business BRT cmpanies: (1) Calculate the median rati f [ntinal value f] OTC derivatives-t-assets fr nn-financial survey respndents; (2) Use this rati t estimate the ntinal values fr nn-financial, publicly traded BRT cmpanies (fr which there is available financial data); (3) Assume a 3% margin requirement paid in cash; (4) Calculate cash balance, cash flw, and liquidity ratis befre and after the margin requirement; (5) Use respected academic literature t estimate the likely reductin in fixed capital spending as the result f the reduced cash flw. Fllwing the abve methdlgy, the analysis indicates that a 3% margin requirement n OTC derivatives culd result in a significant ne-time reductin in cash balances, and an estimated 1% decrease in capital investment amng BRT cmpanies. As f 9/30/2009, the median rati f OTC derivatives (ntinal value) t ttal assets fr survey participants was 17.5%. 4
This rati, based n 27 nn-financial publicly traded BRT cmpanies, was then applied t the remaining 96 BRT cmpanies that are nnfinancial and that are nt privately held firms. The ttal (reprted plus estimated) ntinal value f OTC derivatives fr BRT cmpanies is $1,104 billin. A 3% margin requirement wuld result in aggregate cllateral f $33.1 billin. On average this wuld be equal t $269 millin per firm (median: $105 millin), r rughly 15% f cash n the balance sheet (median: 7%). The margin requirement wuld result in an average reductin in perating cash flw f - 5.5% (median: -4.8%). Shrt-term liquidity ratis wuld decline prprtinally t the reductin in cash balances. The typical (median) BRT cmpany s net wrth wuld decline by -1.3%, and the current rati, quick rati, and acid test wuld fall by -1.6%, -2.0%, and -2.6%, respectively. Academic literature finds that reductins in crprate cash flw lead t reductins in business fixed investment (capital spending). A leading academic study finds that a 1% reductin in cash flw/lagged net capital (CF/LNC) leads t a 0.06% t 0.07% reductin in capital expenditures/lagged net capital (CX/LNC). 2 The average decline in the rati f cash flw t lagged net capital (CF/LNC), due t the psting f margin requirements, wuld be abut 1% (mean = 0.98%; median = 1.32%) The resulting decline in the rati f capital spending t lagged net capital (CX/LNC) wuld average apprximately -0.06% t -0.07%. This means that n a cumulative basis, nn-financial, publicly traded BRT cmpanies wuld be likely t respnd t the impsitin f margin requirements n OTC derivatives by reducing capital spending by -0.9% t -1.1%, r abut $2.0 t $2.5 billin, assuming n exemptins. VI. Jbs Effects fr the S&P 500 Cmpanies It is pssible t extend the analysis abve t the grup f S&P 500 cmpanies. Assuming that S&P 500 cmpanies have rughly the same OTC derivative expsure as the BRT survey participants, then a 3% margin requirement n OTC derivative expsure culd be expected t have a prprtinally larger effect n capital spending. Histrical data shws that capital spending by the S&P 500 s cnstituents ttaled $566 billin in 2008 (latest full year data available). A 1% decline, as indicated in the analysis abve, wuld therefre be equal t apprximately a $5 t $6 billin per year reductin in capital spending. 2 Hvakimian, Armen G. and Hvakimian, Gayané, Cash Flw Sensitivity f Investment (Nvember 23, 2005). Available at SSRN: http://ssrn.cm/abstract=687493. In the case f cmpanies psting a 3% margin requirement fr OTC derivatives, cash flw will take a ne-time hit. Future net capital will decline, but lagged net capital which is assumed t be prir t the margin requirement payment will be unchanged. Therefre, the next perid s capital investment shuld decline in respnse t the drp in cash flw-t-lagged net capital. 5
Based n an analysis f the jbs multipliers prduced by the U.S. Department f Cmmerce s Bureau f Ecnmic Analysis, every $1 billin in capital spending is respnsible fr apprximately 19,643 jbs including bth direct and indirect effects. 3 Therefre, a 3% OTC derivative margin requirement might be expected t eliminate apprximately 100,000 t 120,000 jbs ecnmy wide. 3 The jbs multiplier was created as a cmpsite f the fllwing 13 sectrs: Cnstructin, Oil and gas field machinery and equipment, Paper industry machinery manufacturing, All ther industrial machinery manufacturing, Office machinery manufacturing, Other cmmercial and service industry machinery manufacturing, Special tl, die, jig, and fixture manufacturing, Turbine and turbine generatr set units manufacturing, Electrnic cmputer manufacturing, Other cmmunicatins equipment manufacturing, Autmbile and light truck manufacturing, Sftware publishers, and Custm cmputer prgramming services. These industries are bradly representative f the main categries in the Bureau f Ecnmic Analysis s Natinal Incme and Prduct Accunts investment spending. 6