Reversal of Dodd-Frank swaps rule ignores lessons from financial crisis, ‘London whale’

December 18, 2014

The decision by U.S. Congress last week reverse the so-called swaps ”pushout” rule for certain derivatives contacts will put a greater responsibility on regulators to demonstrate they have effective oversight over bank activities of the sort that played a role in the 2008 financial crisis and ‘London whale’ trading debacle.

Specifically, certain un-cleared credit default swaps comprised most of the contracts that were included in the push-out rule, or Section 716 of the Dodd-Frank Act. The rule requires banks that wished engaged in this activity to place them in separate affiliates with higher capital requirements. As such, they would not be funded through the deposit gathering activities of banks, seen as an important lesson from the financial crisis. 

“It is illogical to repeal the 716 push out requirement,” Federal Deposit Insurance Corporation vice chairman Thomas Hoenig, a former Federal Reserve Bank regional president, said last week. ”The main items that must be pushed out under 716 are uncleared credit default swaps (CDS), equity derivatives and commodities derivatives. These are, in relative terms, much smaller and where the greater risks and capital subsidy is most useful to these banking firms,” he said.

According to industry estimates, such contracts represent only 5 percent of the swaps universe. As Hoenig also noted, most firms have ”broker-dealer affiliates where they can place these activities, but these affiliates are not as richly subsidized, which helps explain these firms’ resistance to 716 push out.”

Congress passed the controversial provision to reverse the push-out rule as part of a $1.1 trillion spending deal to keep the government running. Wall Street reform advocates denounced the action, but the Obama administration accepted it as part of the broad political deal to pass the spending measure.

Insurance vehicle during the crisis

So why had Congress initially felt the need to effectively “tax” on such credit default swaps through the higher capital requirements entailed under the push out rule? While several industry experts were hesitant to be quoted, a few pointed the role credit default swaps played in the financial crisis as a prime motivator. To use a summary from author Michael Lewis’s book, ”The Big Short,” the contracts were more like buying insurance against a potential default than used to hedge positions.

”A credit default swap was confusing mainly because it wasn’t really a swap at all. It was an insurance policy, typically on a corporate bond, with semiannual premium payments and a fixed term. For instance, you might pay $200,000 a year to buy a ten-year credit default swap on $100 million General Electric bonds. The most you could lose was $2 million: $200,000 for ten years. The most you could make was $100 million, if General Electric defaulted on its debt any time in the next ten years and bondholders recovered nothing,” wrote Lewis.

In essence, credit default swaps were often used to speculate on the potential default of companies on their corporate bonds. At the time of the crisis, investors – many of them hedge funds — wishing to bet against, or short, the bonds of subprime lenders, were able to convince major banks – Deutsche Bank, in particular – to sell them swaps against such lenders. The resulting market flourished, and ultimately many Wall Street banks repackaged such swaps into collateralized debt obligations (CDOs).

The appetite for CDOs proved unrelenting, and drew in one of the largest insurers of such securities, American International Group. The insurance giant helped fuel the demand by insuring the CDOs very cheaply, further exacerbating the excesses that needed to be reversed when the crisis peaked.

Hedging vehicle in ‘London Whale’

Yet credit default swaps also had a role to play in the more recent ‘London whale’ episode at JPMorgan. Here again, observers noted that although the bank claimed the swaps were used to hedge their exposure against European sovereign bonds during the debt crisis, what the Chief Investment Office was really up to was buying insurance against a decline in the price of those bonds.

If the bonds went south, JPMorgan would collect on the insurance. But if they didn’t, the bank would keep making premium payments. After some time, the CIO’s strategy changed in wanting even greater exposure to the European market: it actually began to write contracts in which it would receive money if certain corporate bonds held their own, but pay out if they went under. In theory, market conditions played out as expected, the initial buying of CDS against European bonds would be canceled out by the writing of such contracts – the perfect ”hedge.”

As events unfolded, JPMorgan became the largest writer of such contracts, and when the market turned against it, the bank had to pay out billions to investors.

Increased regulatory scrutiny

The swaps pushout rule has been one of the most controversial provisions of the Dodd-Frank Act. It was opposed by the heads of all three federal banking agencies, as well as Paul Volcker. Both Federal Reserve Chairman Ben Bernanke and former FDIC Chairman Sheila Bair said it would increase systemic risk, rather than reduce it.

Yet, if the underlying rationale behind imposing a “tax” on the securities was to dissuade insured depository institutions from engaging in more risky investments, then the repeal passed by Congress last week would appear to increase the burden on regulators to demonstrate that they have effective oversight, say some industry participants.

”I think the regulators are now on hook to a greater extent, particularly in how banks will use credit default swaps in their portfolios” said one legal expert.

”I would expect that these products will get even more scrutiny in the review process,” he added.

Moreover, coming on top of increased frustration among some Congress members over the so-called revolving door between regulatory agencies and the firms they monitor, the ability of large banks to repeal the rule will put agencies under added pressure to ensure proper oversight of such higher risk products.

(This article was produced by the Compliance Complete service of Thomson Reuters Accelus. Compliance Complete provides a single source for regulatory news, analysis, rules and developments, with global coverage of more than 400 regulators and exchanges. Follow Accelus compliance news on Twitter: @GRC_Accelus)

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