Derivative Thinking

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POLITICS APRIL 7, 2010

Derivative Thinking

It would be hard to find a taxpayer who doesn’t know that AIG benefited from tens of billions in government aid during the recent financial crisis. It would probably be just as hard to find a taxpayer who could tell you what a derivative is. Yet anyone still stewing about the former should be up in arms about the latter. While the failure to regulate derivatives was at the heart of the AIG meltdown, the big Wall Street firms that create and trade these instruments are spending millions to make sure they stay unregulated in many cases. And they just might succeed.

To review: Derivatives are essentially a bet on the price of another asset, like a stock or a bond. Beginning in the early 2000s, the financial wizards at AIG used a certain type of derivative known as a credit default swap (CDS) to place big bets on securities backed by mortgages. The bets paid off handsomely as long as real-estate prices rose. But, as the real-estate market began to wobble, the securities started plummeting in value. That left AIG on the hook for billions in losses and brought the company to the brink of bankruptcy.

It would be hard to find a taxpayer who doesn’t know that AIG benefited from tens of billions in government aid during the recent financial crisis. It would probably be just as hard to find a taxpayer who could tell you what a derivative is. Yet anyone still stewing about the former should be up in arms about the latter. While the failure to regulate derivatives was at the heart of the AIG meltdown, the big Wall Street firms that create and trade these instruments are spending millions to make sure they stay unregulated in many cases. And they just might succeed.

To review: Derivatives are essentially a bet on the price of another asset, like a stock or a bond. Beginning in the early 2000s, the financial wizards at AIG used a certain type of derivative known as a credit default swap (CDS) to place big bets on securities backed by mortgages. The bets paid off handsomely as long as real-estate prices rose. But, as the real-estate market began to wobble, the securities started plummeting in value. That left AIG on the hook for billions in losses and brought the company to the brink of bankruptcy.

If that were the end of the story, few of us would have shed any tears. Unfortunately, these bets linked AIG to several other large companies, which were in turn linked to dozens of other companies through additional bets of their own. The upshot is that an AIG collapse would have threatened the entire financial system. The government propped up the company to prevent that threat from materializing, which is where your tax dollars came in.

It’s no surprise, then, that Wall Street’s would-be reformers have made derivatives a major object of their attentions. Above all, they propose forcing anyone who transacts derivatives to “clear” them through a middleman. The clearinghouse would stand between the two sides of each deal and prevent financial turmoil on one side from spreading to the other (and, potentially, far beyond). One way it would do this is by requiring traders to put up cash that could be used to cover bets that go bad. Currently, the companies that sell CDS, like AIG once did, don’t have to set aside any money for future losses. This is a bit like allowing an insurance company to budget as though it will never have to pay out a single claim. Forcing companies to clear their derivatives transactions would bring that lunacy to an end.

To its credit, the administration made clearing a central plank of the white paper on financial reform it released last June. But, as the process of turning the white paper’s proposals into law has unfolded, Wall Street interests have introduced numerous holes. To take the most glaring example, the financial reform legislation that passed the House in December includes an exemption for certain derivatives contracts in which at least one side is not a major Wall Street firm. Under one plausible interpretation, that means a big insurance company could use derivatives to make risky bets with Goldman Sachs, and the bet would remain largely unregulated, just as it was when AIG got in trouble.

As it stands, the bill that Senator Chris Dodd moved through his banking committee on a party-line vote last month includes a somewhat more hawkish approach to derivatives (though still not quite tough enough for our taste). For his part, the president forcefully weighed in around the same time, insisting that “all derivatives must be regulated” and vowing to beat back efforts to water down the bill.

And yet, one could be forgiven for feeling cynical about the fate of derivatives reform. On Capitol Hill, the Dodd language is almost universally regarded as a placeholder, soon to be supplanted by a bipartisan compromise between Democrat Blanche Lincoln and Republican Saxby Chambliss of the Senate Agriculture Committee, which also has jurisdiction here. The expectation is that any Lincoln-Chambliss compromise would be at least as porous as the House legislation, perhaps more so.

The basic problem is that the politics of the derivatives issue, like much of financial reform, are structurally skewed in the direction of Wall Street. Derivatives are obscure and complicated. Even those who appreciate the urgency of regulating them don’t have strong views on the details of those regulations, which tend to be enormously important. As one derivatives industry lawyer told The New Republic this week: “Words on the page are not that critical to the public. ... The public just wants to see something done here.” The obvious temptation for Democrats will be to focus on the few elements of financial reform the public can understand—such as the proposed consumer agency that would police retail financial products like credit cards and mortgages—and cut deals on the rest.

Which means that the only way a tough derivatives measure is going to pass this year is if reformers and their liberal allies make enough noise to check the deal-making. Did someone say something about AIG?

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posted in: politics, goldman sachs, blanche lincoln, chris dodd

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