Derivatives Reform Suffers Midnight Mangling

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The last day was a long one in the House-Senate conference committee on financial reform. The conferees had been at it since 9:00 a.m. and were rumpled and weary. Big bank lobbyists packed the conference room and trailed out into the hallways. As the clocked ticked into the wee hours, the chances for meaningful financial reform dimmed. At issue was the strong and controversial crack-down on derivatives trading authored by Senate Agriculture Committee Chair Blanche Lincoln (D-Arkansas).

Taxpayers Still Back Reckless Wall Street Trading

At about midnight, House Agriculture Chairman U.S. Representative Collin Peterson (D-Minnesota) offered an amendment to the Lincoln provision to require big banks to spin off (or push out) their derivatives desks into a separately capitalized affiliate. The Lincoln measure was geared toward ending taxpayer supports (FDIC insurance, Federal Reserve monies) for Wall Street gambling.

Under the Peterson language, the push-out provision was gutted. Some categories of trading were pushed out: including commodities such as gas and food but excluding gold, equities, and junk rated credit default swaps. The vast majority of over-the-counter (OTC) derivatives (approximately 90% were not pushed out.) These include interest rates swaps, foreign exchange trades, investment grade credit default swaps, gold.

This means that at the end of the day, taxpayers are still on the hook for the Wall Street casino. Taxpayers will be incensed to discover this the next time these trades go bad and blow up a “too big to fail” institution. The New Dem coalition and the New York delegation who pushed for this hatchet job must be held accountable in November.

However, a great deal of progress was made to bring derivatives out of the shadows and into the light of day. The fact that most derivatives trades will be cleared and exchange traded with capital requiremen, and will bring real transparency to the marketplace for the first time. These measures will make it much costlier to engage in speculation, plus regulators now have the tools to crack down on speculation. Commodities Future Trading Commission (CFTC) Chairman Gary Gensler, who had been critical of oil and gas speculation, now has the tools to pop these speculative bubbles when they occur.

Frank Failed to Protect Localities

Lincoln also lost her battle to protect state and local government from bad swaps deals by applying a fiduciary responsibility to swaps dealers who sell to localities and other government entities. Activist have identified at least 71 localities who were sold sophisticated swaps. Many of these governments took huge losses when these bets went bad. House Finance Committee Chair Barney Frank (DMassachusetts) succeeded in gutting this provision and watering it down to a "code of conduct" requirement leaving states and localities vulnerable to the Wall Street con.

Brown Blows Loophole in Volcker Rule

The Volcker Rule also took a big hit. The rule bans “proprietary trading” or trading for the bank’s own account rather than for customers. The committee passed a strengthened Volcker rule by including the language prepared by Senators Merkley and Levin. The advantage of Merkley-Levin is that it covers more types of proprietary trading than the original rule proposed by the administration.

However, conferees blew a hole in the proprietary trading ban at the request of Senator Scott Brown (R-Massachusetts), whose vote may be needed in the Senate to pass the bill. The amendment allows banks to invest in hedge funds and private equity funds. The rule allows them to invest 3% of their private equity capital. This sounds like a small number, but this money can be hugely leveraged. So, for instance, Bear Stearns put $40 million into a hedge fund during the heyday of the housing bubble, and had to pony up $3.2 billion when that investment backfired in 2007 -- literally 80 times what they put into it. This may be one of the worst provisions in the bill, and Brown was aided by the New Dem coalition in his fight to deliver this loophole to Wall Street.

Future Fights

The lack of progress on separating the taxpayer guarantee from the big bank derivatives trade leaves taxpayers on the hook for a future derivatives crisis. When these crises inevitably occur, they will give new fuel to measures such as that offered by Senators Sherrod Brown(D-Ohio) and Ted Kaufman (D-Delaware) to shrink the size of “too big to fail” institutions so that taxpayers will not have to go down with the Wall Street titans.