ECONOMY APRIL 20, 2010
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Some two dozen executives from large corporations will be descending on Capitol Hill today to make the case against over-regulating derivatives. The “fly-in” is being organized in part by the U.S. Chamber of Commerce through a group called the Coalition for Derivatives End-Users, according to the Chamber’s Ryan McKee. Many corporations use derivatives to hedge against fluctuations in the price of their inputs—for example, an airline might sign a contract to lock in future fuel prices, thereby passing the risk along to someone else. And so, on one level, it makes perfect sense that the executives and the Chamber would take an interest in derivatives legislation.
But, on another level, the pilgrimage by the so-called corporate "end-users" is a little mystifying. That’s because the legislation that’s piqued the executives’ interest—a derivatives bill that Senate Agriculture Committee Chairman Blanche Lincoln unveiled last week—explicitly exempts derivatives used in commercial activity, as in the jet-fuel example. What the Lincoln bill would regulate is the use of derivatives for more speculative purposes, like a straight-up bet between two Wall Street firms on the future price of oil.
Which suggests another explanation for today’s fly-in: Big financial firms like Goldman Sachs and JP Morgan generate billions of dollars each year as derivatives dealers. But, over the past several weeks, as Democrats’ have escalated their rhetoric and explicitly targeted Wall Street, the big banks have had trouble getting their message out on Capitol Hill. All the more so thanks to Friday’s SEC complaint accusing Goldman of fraud. “The banks’ credibility, their ability to influence this, is limited,” says one derivatives industry lawyer.
And so, instead of mostly making the pitch against regulation themselves, the big derivatives dealers are counting on their corporate clients to do a lot of heavy lifting for them. “The end user ability to do that is going to be pretty critical,” the lawyer says. “I think it would be naïve to think companies have not been talking to their bankers about how the business is going to be affected going forward.” That this conversation has yielded a well-coordinated trip so close to the endgame on financial reform is a sign of how much ground the banks have lost in such a short period of time.
The reason the recent developments are so remarkable is that all reforms tend to weaken as they get closer to passage, as legislators hash out compromises with powerful interests in order to secure a deal. Bizarrely, financial reform appears to be headed in the opposite direction. When it comes to derivatives, at least, the bill Senator Chris Dodd moved through his Banking Committee in March was significantly tougher than the bill the House passed in December. Then, last week, Lincoln shocked Wall Street by producing an even tougher bill than that. “This thing is not a battle they’d anticipated,” says one administration official. The industry had widely expected Lincoln to soften Dodd’s derivatives measure as part of a compromise with her Republican counterpart, Saxby Chambliss. (The Senate Banking and Agriculture Committees share jurisdiction over derivatives.)
What happened? For weeks, Wall Street had viewed the Dodd language as a placeholder while Lincoln and Chambliss hashed out the real details. Instead, the practical effect of the Dodd language was to create a minimum standard of toughness from which Democrats would be unwilling to retreat. As Lincoln and Chambliss bargained in March, the administration began to focus on the issue and discovered its popular resonance. “I have a clear memory of the time the House passed [its financial reform bill] in December. I directly tried to engage the White house … It was pretty much a non-event, primarily because of health care,” recalls Rep. Chris Van Hollen, who heads the House Democrats’ campaign arm. “It’s been a total transformation … a quantum leap in engagement.” By the time Lincoln finally sent the administration the contours of a possible deal with Chambliss the week of March 29th, there was no way the deal could pass muster. Several days later, Michael Barr, the assistant Treasury secretary with the derivatives portfolio, told Lincoln's staff the administration would be unable to support it because it weakened the Dodd bill.
That left Lincoln with a dilemma: She’d been planning on moving the compromise through the Agriculture Committee with bipartisan support, meaning she could afford to lose a few liberal Democrats. Now that she’d be losing Republican votes to win the administration’s imprimatur, she’d have to construct a political coalition that would bring the liberals aboard. The result was the apparent lurch from what was widely expected to be the weakest derivatives bill on the Hill to what’s far and away the strongest.
That was last Tuesday. As of Thursday night, it still wasn’t entirely clear whether Lincoln had calibrated correctly. The bill was so much more hawkish than anything that had come before it—one provision could effectively ban big banks from trading derivatives outright—that it risked repelling not just Republicans but moderate Democrats. (Ben Nelson and Max Baucus both sit on Lincoln’s Agriculture committee.) Then came Friday’s Goldman revelations and suddenly Lincoln had the upper hand. “I’ve heard there’s been some folks on her committee pushing back a little bit,” says a former Democratic Senate aide who now consults for the financial services industry. But, “if you’re a Democrat, it’s harder to vote against something after the Goldman stuff. It puts pressure on Republicans and pressure on Democrats.”
This same person sees an analogy to Sarbanes-Oxley, the tough regulation of corporate accounting statements that Congress enacted after Enron. The bill had begun to stall in the Senate while its sponsor, Paul Sarbanes of Maryland, spent months methodically holding hearings. Then WorldCom imploded, and the bill became a juggernaut. “It was like a freight train. It was on the floor and no one was getting in front of it,” recalls the former aide. “Goldman to me is a little analogous… Except that [financial reform] was already on the track. It had some momentum. This helps give it a considerable amount more.”
At this point, the industry is banking on three things to save it: One is the efforts of the corporate executives visiting Capitol Hill today. It’s one thing to stiff-arm Wall Street not long after a financial crisis; it’s another to reject the pleas of companies who employ hundreds of thousands of people across the country (even if they may be talking Wall Street’s book). The second is that the mere passage of time may ratchet down tensions. “The current strategy that I’m hearing is basically to keep the Republicans together till cooler heads prevail,” says the derivatives industry lawyer. “Not to overreact to current events, not go too crazy.”
Finally, there’s the argument, which top Wall Street executives have conveyed directly to senior White House officials in recent days, that the administration faces almost as much peril as Wall Street does if it brings a partisan bill to the Senate floor. Should that happen, the argument goes, Senate liberals like Maria Cantwell and Byron Dorgan could triumph on amendments that would move the bill well to the left of where even the administration wants it. (In a telephone interview Monday afternoon, Dorgan allowed that he was “thinking through how to approach the too-big-to-fail piece” and that he might offer an amendment, though he was amused by the idea that it would represent a radical leftward thrust.)
Alas, it doesn’t look like the White House is biting just yet. “I think right now, everyone sort of sees it as win-win-win,” says a senior administration official. “Frankly, Rahm’s hearing from friends in the financial industry that he should cut a deal before it goes to the floor--that probably makes him less likely to do that, work this out. Rahm's like, ‘let's not work it out.’”
To be sure, Dodd continues to negotiate with Dick Shelby, his Republican counterpart on the Banking Committee, in the belief that he can strike a deal in exchange for only a handful of cosmetic, face-saving concessions. And, given the palpable anxiety on the Republican side, some Senate aides I spoke with think he’ll get it before the bill goes before the full chamber, possibly late this week. But, for the moment, the White House seems happier to make the banks and the GOP squirm. “Probably the way it's playing out … [we’d] make them vote a bunch of times against [a tough bill], then compromise. You’d still have a strong enough bill, but peel off five to ten votes to get it done.” The idea is to force Republicans to pay a price for their reflexive opposition--“make them actually block it, not just say they're going to block it”--before you finally throw them a lifeline.
The one tactical question Democrats do agree on is that the GOP is ready to crumple. Last week much was made of Senate Minority Leader Mitch McConnell’s success at getting all 41 Republicans to sign a letter of opposition to the current Dodd bill. But Democratic Senate aides have been privately mocking the letter’s mealy-mouthed language, which is carefully parsed to afford its signees maximum wiggle room. “There’s no explicit threat to vote against [opening debate],” scoffs one senior Democratic aide. “It pledges to continue negotiating.” If Wall Street has a few more sympathetic Main-Street execs up its sleeve, now would be the time to play them.
Noam Scheiber is a senior editor of The New Republic.
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10 comments
This is great news! Democrats should really just write their dream bill (ideally the harshest for Wall Street they can come up with), and if the Republicans filibuster, run to pass that bill word for word in November. Like a Contract for America, but only good for America. Make it a litmus test in every Senate and House race. If they did it right they could pick up seats instead of just minimizing losses, people are that angry at Wall Street.
- vips73
April 20, 2010 at 1:29am
an article analyzing the different economic effects rather than the partisan effects of the various bills, including the new and potential harsh ones compared to the weak house bill would be greatly appreciated.
- Maxblum13
April 20, 2010 at 1:48am
Big waste of time. The only significant issue is the effective leverage of financial institutions, including the implied liabilities of derivatives contracts for which they are on the hook. The implied liabilities should be on their balance sheets -- which would show that their true leverage is stratospheric, far beyond what they are theoretically allowed to have. Once it is on the balance sheets, insist that it be brought down into the normal range, call it approximately 10:1. Then discount the asset side of derivatives as the default risk is huge. If they still want to chew up their capital this way, let them. There will be no big downside other than the fact that no one will be around to finance the real economy -- but that won't happen. The margins on derivatives are too small to make them a viable business once the leverage is limited and the capital requirements are high. The derivatives business should consist entirely of exchange-traded standard contracts, just like the rest of the commodities markets, and private one-off deals between parties that want to trade risk -- but without credit guarantees by financial institutions in any case. Because we are at risk for what financial institutions do, they need to be out from the middle of all derivatives other than those that explicitly hedge their own portfolio risks. The rest is just commentary.
- roidubouloi
April 20, 2010 at 2:42pm
Well put, Roid. Another critical measure is once you've disclosed the implied liabilities, then let those that risk it all actually fail if that is in the cards. Let the lawsuits fly. Let the criminal and civil charges work their way through the courts. Let people go to jail. Let greedy investors get stuck with pennies on the dollar. In other words, let the market work.
- seattleeng
April 20, 2010 at 4:17pm
I don't know if there's a tax on these things, even though you're really buying something. If there already is a tax, make it higher. Legit users who need to hedge prices will be willling and able to pay it, but speculators will find it increasingly indigestible as they take on a number of positions. A tax would limit their ability to warp the market, and give the US government a reserve for emergencies in the market. (Unless traders price in the tax and the existence of and size of a reserve as a market factor to game. Ow my head....)
- haricot
April 20, 2010 at 7:03pm
The bulk of derivatives are standardized, and should therefore be traded through an exchange - I think most everyone agrees with this. The solvency of the exchange would then be the only systemic risk, which, given the requirements of daily margin and mark-to-market, the history of our exchanges, and especially the relative ease of regulating them, implies minimal risk. I can understand the need for limited customized derivatives, and think it a serious negative to ban them. But haricot's tax suggestion, or a substantial margin requirement - scaled to the relative ease of a neutral party determining fair value - would retain with restrictions a potentially valuable tool - for hedging or speculation. Noam, there is nothing wrong with speculation. Naked speculation, without sufficient margin to back it up is the problem. This is what AIG was doing writing CDS on crappy mortgages or synthetic CDO's of crappy mortgages. ACA too it looks like, in the Goldman/Paulson deal. Had the CDS been on an exchange - and if they used standardized language, they could have been - then the collateral requirements would have shown up much more quickly. AIG might still have gone bust, but the resolution would have been quicker and cleaner, perhaps not requiring Federal involvement. Moreover, it would likely have been speculators, large and small, as well as overexposed bank, finance, construction, etc commercial hedgers who would have had a say in the market assessment of the risk in those transactions, and ultimately in the amount of collateral AIG et al would have had to put up. Lincoln's bill is misguided in that while it would require exchange trading, it would discourage the depth and liquidity that comes from speculators. Lastly, this kind of legislation (any?) tends to help the biggest players more than the smallest. I believe most regulation does that, which is why the largest players love more regulation. Note the collapse in the number of small banks and brokerage firms as the regulatory apparatus has steadily increased. It may be more efficient and easier to manage, but it tends to reduce, not increase, competition, and concentrate rather than disperse risk. Whatever the political angle, bad legislation is a mistake.
- ds111
April 21, 2010 at 7:46pm
There is nothing wrong with speculation except when financial institutions engage in it. They should not be on the hook for derivatives contracts, whether they are standardized or customized, and they certainly should not be allowed to exceed their leverage limitations because the liabilities arise from synthetic instruments. I agree that exchange-traded derivatives with normal margin and mark-to-market requirements and the exchange itself as the "guarantor" do not present any unacceptable risks and have the potential to be a good indicator of market sentiment. But financial institutions, with their de facto government guaranteed liabilities, need to be completely out of it, unless they are hedging their own assets and liabilities. Nothing less will do. If we allow them back into being guarantors, we will have a repeat of the 2008 meltdown. The leverage makes it inevitable. Repeat, rinse, and repeat: Long-Term Capital. Long-Term Capital. Long-Term Capital . . .
- roidubouloi
April 21, 2010 at 11:06pm
Max: agree - a bit too much red meat for TNR, in particular Noam. Roi: In the relevant proposals, virtually all large financial institutions will be subject to FDIC solvency controls, not because of their insured deposits, but because of their potential systemic risk. They are also some of the biggest players in the commodity and financial futures and options markets, and by extension, other similar but more complex derivatives. Their volume alone, whether for customers, hedging, or speculation makes it impractical, even reckless to take them completely out of it. Historically sound 10-1 type leverage requirements makes sense. That, and on-exchange derivative trading would solve the bulk of the risk problem - obviating the need for open-ended FDIC/FED involvement - in my view the most reckless and misguided aspect of Dodd's (et al) otherwise reasonable proposal. But I still don't know how to address over-the-counter derivatives, which are unsuited to exchanges. Banning them is a mistake I believe, because most tailored derivatives have value. The only firms with sufficient expertise will likely be financial firms. The question is how to minimize systemic risk, without eliminating a valuable tool? Perhaps a separate corporation under the aegis of a regulator - possibly a separate arm of an existing exchange - to monitor collateral requirements and verify that both (more?) sides agree. The corporation would be user funded, and segregated such that the risk would only relate to the involved parties. It would be expensive, discouraging frivolous contracts. This is the kind of stuff that a regulator would need to regulate. But, as we've seen before, who will regulate the regulator, and in real time?
- ds111
April 22, 2010 at 12:29am
The main problem as far as financial institutions go is that they stand as intermediaries in these derivative contracts, so that the parties do not have to take credit risk. Just because the people who would like to be able to engage in derivatives transactions would like not to have credit risk is absolutely ZERO reason for us to allow financial institutions to be used in this way None, nada. Similarly, if there is not enough speculative demand in the derivatives market without financial institutions as players, tough. There is no god-given right to buy and sell whatever you want with the liquidity and risk that you would like. The solvency controls are irrelevant. There have long been solvency controls. If the financial institutions have de facto leverage much in excess of 10:1 the controls are effectively moot -- there are none whatever it may say on paper and whatever the supervisory authority. When these crises come, there is no adequate time to react to avoid them or the institutions with the excessive leverage would do so. The reality is that if the leverage implied by their derivatives contracts were on the books and they were limited to 10:1, the financial institutions would have zero latitude with which to speculate. The simply would not have the ability to take on the liabilities. This is what we need to do. The world existed before the derivatives market. It will exist with a derivatives market in which there are only principals, no intermediaries, other than a regulated exchange or two. In that manner, the market will also inherently be limited to something appropriate to risk management for the real economy rather than serving as a giant casino in which we are all on the hook.
- roidubouloi
April 22, 2010 at 10:05am
Although disclosure wouldn't have prevented this, the paper trail left behind allows the SEC to have fun with the fraud hammer. And if you were listening to Bloomberg when this all happened, it electrified the street like nothing I've ever heard. There was an air of stunned disbelief. There has been been only careful fightback from the industry, because who's next? I think in the long run, there will be more prudence and more skepticism on the part of smaller investors. My grandfather had that mindset after the Depression, but my generation laughs at it. I think the only thing that will keep America stable is our vast reserves of loose money going into factories, power plants, and buildings, not paper. DS: I am blushing. Such a small man among these brains.
- haricot
April 22, 2010 at 7:52pm