For weeks now, suspense, like springtime pollen, has flitted through the air in Washington. The reason is something that almost no one in America understands: derivatives. One type of these complex financial products–credit default swaps–played a central role in the recent financial collapse, serving as a sort of Trojan Horse that hid vast amounts of unregulated leverage that threatened to raze financial institutions once the housing market collapsed. As a result, U.S. taxpayers spent billions of dollars bailing out postmodern financial wizards who had pocketed millions of dollars making meta-bets they could never pay off. Everyone agrees that new derivatives regulations are needed to head off another financial implosion, but there is huge disagreement about which derivatives should be regulated and how.
Complicating things further is the fact that the five largest banks–Goldman Sachs, Citibank, J.P. Morgan, Morgan Stanley, Bank of America–control the vast majority of the derivatives market, and make a mint doing it. As it now stands, derivatives are largely traded over the counter, meaning they are private arrangements between two or more parties. Without a transparent market, banks are able to take a significant cut off of each trade, yielding roughly $20 billion in profits last year. The problem is that this same system conceals risk. Without transparency, regulators cannot know for sure whether banks or other parties in derivatives transactions actually have the ability to pay off their bets if things go bad. The system functions very much like a dimly lit casino, but in this casino some people bet with far more money than they have or can get. When the dice come up box cars, taxpayers must come to the rescue, or watch the markets freeze in fear.
Which brings us to the suspense: Bank lobbyists care as much about derivative regulation as any part of financial regulatory reform, since there is so much money at play, and they have been pushing for months to set up the Senate Agriculture Committee as the vehicle for watering down these provisions in the bill. The committee is run by Blanche Lincoln, a Arkansas Democrat who has been warring with unions and distancing itself from the White House. Lincoln has long promised a bipartisan effort with ranking Republican, Saxby Chambliss, who hails from Georgia, a center of derivatives trading. His son, Bo, was also until recently an industry lobbyist for the Chicago Mercantile Exchange, working on derivatives issues. Those working against the banks on this issue all worried that Chambliss and Lincoln would carve out huge new loopholes, and no one would notice since no one really understands what a derivative is.
But that hasn’t happened. Two weeks ago, Former Fed Chairman Paul Volcker, a White House adviser, issued a public warning about the need to fight back against the bank lobby on derivatives, and last week a group of top Treasury officials met with the White House press corps to announce that they planned to hold the line. The open question was Lincoln. Which side would she take? One report claimed Tuesday that Lincoln was working on more loopholes, but they seem to have been proved wrong.
Late Tuesday afternoon, I got a surprised email from one of the outside advocates working against the bank lobby on these issues. “It sounds like the White House, Senate Leadership, etc are all intervening to say that the bill out of Senate Ag has to be a tough bill and not a watered down bill,” my correspondent wrote. “So everything that was discussed last week seems to be out the window in a good way.”
Chambliss vented his frustrations Tuesday, blasting the White House for meddling with his plans for the committee:
“My staff and I have worked diligently over the last several months with Chairman Lincoln to craft a bipartisan plan that we believe would have received wide bipartisan support in the Senate Agriculture Committee,” Chambliss said. “Unfortunately, the White House, Secretary Geithner and Chairman Gensler have forced politics in the pathway of meaningful financial regulatory reform. They seem to be intent on making this a partisan issue without Republican input, which in no way benefits the American people who have endured economic distress as a result of the recent financial crisis. Partisan politics have no place in economic policy. Despite efforts by the administration, I remain committed to working with Chairman Lincoln and her staff in moving the process forward.”
This fight is far from over. Next week, coalitions organized by the bank lobby plan to barnstorm Congress to make their case, and floor votes are sure to follow. This least understood part of reform, may in the end, be the most important factor in determining passage. But for today, the bank lobby has taken a major hit. As the front page headline atop the Wall Street Journal reports, “Banks Falter In Rules Fight.” This is not the sort of thing that the bank chiefs want to be reading.