Opinion

The Great Debate

Lincoln’s win a big stick for derivatives reform

By Reuters Staff
June 10, 2010

The following is a guest post by John Wasik, who is the author of “The Audacity of Help: Obama’s Economic Plan and the Remaking of America.” The opinions expressed are his own.

There is yet to be a final decision on the financial regulation bill, but the odds for the toughest part of it – the derivative legislation known as the Lincoln proposal – just got better.

With Democratic Senator Blanche Lincoln’s win on Tuesday, the Arkansas primary run-off has given her and fellow reformers a big stick to rein in derivatives abuses.

Now the Democrats on the conference committee negotiating the final reform package will water down Lincoln’s tough derivatives proposal at their peril. Lincoln has become the de facto torch bearer for cracking down on Wall Street. Neutering her plan significantly would make the Democrats look like bankers’ lap dogs.

Despite Lincoln’s political momentum, her proposal still faces a blizzard of money and lobbying from a financial services industry that wants to freeze it out.

The biggest banks have a huge stake in protecting their derivatives profits since they control about 97 percent of the swaps market. So Bank of America, Citigroup, Goldman Sachs, JPMorgan Chase and Morgan Stanley are not likely to concede any ground to Lincoln without a bare-knuckled fight to insulate a business that generated more than $22 billion in profits for them last year.

Both the White House and Wall Street also shun Lincoln’s proposal and want less-stringent measures. Even the ultra-Democratic Representative Barney Frank of Massachusetts, one of the committee’s most powerful conferees, is not keen on her proposal.

Lincoln wants to create a mandatory exchange and clearinghouse for all unregulated and speculative derivatives, particularly credit default swaps, which acted like debt insurance — only without any reserves to back them up. Exposure to swaps and a near chain-reaction meltdown in the global financial system led to the failure of Lehman Brothers and the government takeover of the AIG Group. An estimated $12 trillion bailout of the financial system followed.

While creating transparency in a part of the $60 trillion derivatives market, Lincoln would also prohibit any money flowing from the Federal Reserve and the Federal Deposit Insurance Corporation to “bail out Wall Street firms who engage in risky derivatives deals.” This is a back-door way of limiting the too big to fail doctrine — at least on the derivatives exposure issue.

A more subtle Lincoln provision — one loathed by Wall Street — is a requirement that would make banks and swaps dealers fiduciaries. This is a stringent legal standard to compel banks to act in their customers’ best interest.

A fiduciary duty in selling derivatives would likely also protect pension funds and municipalities from these egregious practices and eliminate the practice of dealers like Goldman Sachs selling debt-related instruments and then betting against their clients.

The U.S. Chamber of Commerce and Financial Services Roundtable have spent more than $158 million in lobbying against financial reform in 2009 and through the first quarter of this year, reports the Center for Public Integrity.

In lieu of a direct “too big to fail” policy that would break up big banks and sell off assets in the event of another derivatives-triggered meltdown, it’s impossible to have true financial reform without monitoring these “financial weapons of mass destruction,” which is how investor Warren Buffett referred to them.

Imagine a world in which American taxpayers and the Federal Reserve cover all of the bad bets of Wall Street and shadow banking operations dealing in derivatives. It’s a casino in which the worst gamblers get bailed out. That’s what we have today.

Whatever emerges, global financial players will need more transparency to better identify their risks and preserve hedging abilities. Even-tougher rules in Europe will demand some kind of harmonization with U.S. rules.

The amorality of Wall Street enflamed Main Street long ago. U.S. taxpayers from progressives to Tea Partiers are livid about covering Wall Street’s losses.

As former Federal Reserve Chairman Paul Volcker, a strong backer of meaningful banking regulation, noted in a May 25 New York Review of Books piece: “The essential logic is that the taxpayers need not, and should not, be called upon to support essentially speculative activities within the protected, implicitly subsidized financial sector.”

Good politics can often beget good regulation; it’s the cudgel that may keep unruly and rapacious casino gamblers from putting the global financial system on life support again.

Photo caption:

Traders work on the floor of the New York Stock Exchange as a television shows President Barack Obama speaking at Federal Hall, September 14, 2009. Obama, marking a year since Lehman Brothers collapsed, urged financial firms on Monday not to fight regulatory reform and called on Congress to pass his proposals by the end of the year.

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