716 Wall Street Reform: A Good First Step

Zach Carter — Fri, 25 Jun 2010 13:27:23 -0400

Members of Congress finished ironing out their differences on Wall Street reform last night, and the resulting bill deserves unequivocal support from progressives and conservatives alike. But while the final package is a necessary first step to overhauling the nation's out-of-control financial sector, it will do very little to change the destructive status quo on Wall Street. The bill is a good first step. The public deserves too see stronger reforms from Congress next year.

As a matter of history, sweeping financial change takes several years to secure. It took Franklin Delano Roosevelt seven years to enact all of his New Deal banking regulations, and President Barack Obama appropriately sees the 1930s crisis as the historical analog to today's meltdown-and-reform process. Obama is correct to state that the legislation approved by Congress late last night is the most significant since the Depression—but it is a hollow truth. The U.S. government has been steadily deregulating the banking industry ever since Roosevelt, and the mere act of moving policy in the opposite direction is enough to claim the mantle of dramatic reform. Actually living up to the precedent set by Roosevelt will take several years of serious work, and major legislative action during the next electoral cycle.

As for the current bill, Congressional leaders decided late last night to gut the only two serious structural reforms still on the table. With the political wind at their backs, and the finish line clearly in sight, lawmakers decimated an effort to end outright gambling by the nation's largest banks, and sabotaged a plan to rein in rampant speculation in derivatives—the out-of-control market that brought down AIG and necessitated the bailouts of every major U.S. bank. By adopting the plan from Sen. Blanch Lincoln, D-Ark., to fix derivatives and implement a strong version of the Volcker Rule banning proprietary trading, Congress could have made significant strides toward ending the too-big-to-fail financial oligopoly that held taxpayers hostage in 2008. Instead, Congress chose to reinforce the current destructive banking regime.

But while the resulting legislation will not end too-big-to-fail, prevent future bailouts, or significantly rein in risk-taking on Wall Street, it is nevertheless worth supporting. Three important measures made it through that will make the global economy a fairer and more just marketplace. Those three reforms will not be enough to prevent future financial crises, nor will they be able to ameliorate the fallout from those crises once they occur, but they are nevertheless critical.

First, we will get a thorough audit of the Federal Reserve, an agency which has funneled $4 trillion in bailout funding to the nation's financial system without any oversight or transparency. The public will finally know how it's money is being spent, and credit is due to Rep. Alan Grayson, D-Fla., Rep. Ron Paul, R-Texas, and Sen. Bernie Sanders, I-Vt., who fought hard for the plan in the face of overwhelming Wall Street lobbying. Kudos are also due to activist journalists Mike Elk and Jane Hamsher, who cobbled together a coalition of good government supporters across the political spectrum and made the Fed audit a centerpiece of the legislative debate. The Fed's blunders on the bailout of AIG have created significant momentum for real reforms, and further information about the secretive agency's operations will help build momentum for next year's financial fights.

The legislation also includes a critical overhaul of the nation's consumer protection regime wherever banks are concerned. For the first time, the public will have a regulator dedicated to defending consumers against bank abuses, with no other conflicts. The new Consumer Financial Protection Bureau has been pilloried with unnecessary loopholes, but the resulting agency will nevertheless be able to write and enforce meaningful regulations on the financial sector. This is a major accomplishment, made all the more significant by the fact that the front-runner to head the new agency has already established herself as one of the most important voices on U.S. economic policy.

As Chair of the oversight panel for the Troubled Asset Relief Program, Elizabeth Warren has taken a position with extremely limited statutory power and converted it into the only mouthpiece for the American middle class in Washington, D.C. She has done a far better job than even the most optimistic good government activists had hoped for, and giving her free reign to crack down on consumer abuses will be a major victory for the American economy. She has not been formally nominated for the post yet, but the world will be a better place once she is.

Finally, while Lincoln's derivative overhaul was largely destroyed, she did manage to preserve tough new rules regulating both food and gas derivatives. The resulting legislation will not keep Wall Street from gambling with our future, but it will make it much more difficult for financiers to jack up the prices of basic necessities in their quest for bigger bonuses. Back in the spring and summer of 2008, prices for food went through the roof as a result of heavy speculation in market for agricultural derivatives—raw bets placed on the future price of corn, rice and other farm products. The resulting price increases forced consumers the world over to pay too much for food, and sparked outright starvation in regions that could not afford the increases.

The same thing happened with gasoline. Remember paying over $4.00 a gallon? That had nothing to do with the fundamentals of supply and demand—it was a direct result of wild speculation in the market for energy derivatives. The bill approved last night will end that abuse. As a result of Lincoln's efforts, two excesses that created real, tangible hardship for millions of people will be eliminated.

This bill is unquestionably deserving of support. It will make the global economy a fairer marketplace. But it will not end the too-big-to-fail incentives that encourage Wall Street to take wild risks and stick taxpayers with the tab, nor will it sufficiently overhaul the market that brought down AIG, nor will it end the widespread practice of bigwig bankers gambling with taxpayer money. All of those reforms could have been enacted—explicit, concrete amendments were offered on all three, and Congressional leaders rejected them in an overt effort to rake in campaign contributions from Wall Street. Republicans resort to such political calculations all the time—catering to entrenched corporate interests has been their only economic strategy since the Reagan years. But it is enormously disappointing to see significant swaths of the Democratic Party adopt the same strategy (particularly the New Democrats, who should rename themselves the Wall Street Democrats after this episode) and even more frightening to see the Democratic leadership incapable of corralling these turncoats.

So support the Wall Street reform bill: it's a good first step toward building an economy that works for all citizens, not just bankers. But demand that your elected leaders finish the job next year. Too-big-to-fail lives on, and must be defeated.

The Bank Lobby Gets Desperate on Derivatives

Zach Carter — Wed, 23 Jun 2010 14:10:13 -0400

Astonishingly, as Wall Street reform enters its final hours a tired, generic corporate refrain against regulation is gaining traction. As bigwig bankers and their lobbyist brethren fight to defeat tough new rules on derivatives—the crazy casino that brought down AIG—all their sloganeers can come up with is the trite wail that serious rules will send this risky business overseas. It'd be funny if members of Congress weren't taking it seriously.

"Oh no—the business will go overseas!" is the last-ditch, we're-about-to-lose-this-one cry of despair for corporate executives in every industry. Crack down on a profitable abuse in the United States, and the entire business will move to London or Mumbai, sending jobs and tax revenue abroad-- or so the argument goes. You only hear this line when CEOs know they have no case, and have to divert attention away from the real substance of the policy debate. In the case of Wall Street abuses, this nonsense is especially ridiculous. The bank lobby really just doesn't have any good arguments to launch in its favor, so it's falling back on generic corporate jargon.

In reality, the U.S. has extremely broad authority to crack down on derivatives activity abroad, we just don't have a whole lot of good rules on derivatives for regulators to enforce. It's extremely difficult for financial institutions to simply offshore their risky derivatives business to avoid oversight. Under current law, the Commodity Futures Trading Commission has the authority to regulate any trading done by foreign firms on behalf of U.S. clients, any trading of U.S. assets conducted by foreign institutions and any trading that causes a "substantial disruption" in U.S. markets. Just about anything the CFTC wants to get its hands on, it can, and the current CFTC Chairman, Gary Gensler, is a committed reformer. We just need to write good rules for his agency to enforce.

Moreover, finance tricksters will have no incentive to move their destructive derivatives trading abroad, because the rules in other countries are, in fact, much tougher than those the U.S. is currently considering.

There are a lot of ways to crack down on Wall Street, but none of them will work without reining in the insane, secretive market for derivatives—speculative instruments that allow financiers to gamble on anything from subprime mortgages to the price of corn. Right now Wall Street is making a big push to roll-out new derivatives on movie box-office receipts, allowing the financial world to place raw bets on how much money a movie is going to make. It sounds crazy and destructive, and it is.

Germany is leading the way on derivatives reform by simply banning this kind of naked gambling outright. The U.S. effort is critically important, but much more modest. Instead of banning the casino, reformers in Congress are hoping to shrink it by ending the taxpayer subsidies that fuel it. This is at the heart of the proposal from Sen. Blanche Lincoln, D-Ark., that has earned so much ire from the bank lobby. Bankers love their taxpayer subsidies, and love converting them into bonuses—who wouldn't? The trouble is that this business is inherently risky, and can jeopardize the entire economy, as the collapse of AIG attests.

But ending subsidies is still not as strong as banning gambling, which Germany is doing. The entire European Union is currently making a move to follow Germany's lead. Businesses can't exit U.S. markets to skirt regulations if their Wild West trading schemes are outlawed everywhere else.

In the U.K., officials are poised to impose a hefty tax on all financial assets, prevent banks from ballooning their balance sheets with derivatives trades. That means, U.S. banks can't send their derivatives operations to the U.K. without paying a big price.

Outside of Europe, few nations have the financial infrastructure to support derivatives trading on the scale of what we currently have in the U.S., where $300 trillion in trades are housed at just five banks. Some Asian nations do have this kind of infrastructure, big financial firms in Asia all realize that they will have to comply with U.S. rules if they want to keep doing business in the U.S. And indeed, policymakers in Hong Kong and other financial centers are looking to the U.S. for leadership on derivatives, and are likely to mimic whatever reforms are adopted here.

But more broadly, we have to ask why the U.S. should be worried about this activity being offshored at all. Raw gambling by financial institutions brought on one of the greatest economic catastrophes in American history. It forced the government to pony up over $4 trillion in bailout funds, expanded the national debt by 40 percent, and killed over 8 million jobs. If this business goes overseas, so be it! Let other nations bailout their megabanks and wreck their own economies if they want to. Today's derivatives casino is a job-killing nightmare that produces nothing other than megabonuses for bankers. Taxpayers have no business subsidizing such economic destruction.

Compared to international efforts, Blanche Lincoln's derivatives bill is overpoweringly mild, but it remains the only serious attempt to rein in the speculative casino that crashed our economy. The fact that the bank lobby's only tactic left is the wail "offshore!" shows how desperate our bank executives have become. Congress has no business caving to such nonsense at this stage of the reform process.

A Last-Minute Wall Street Sell-Out By New Dems?

Zach Carter — Wed, 23 Jun 2010 11:17:02 -0400

A coalition of conservative New Democrats, whose leader is being investigated by a Congressional ethics committee over Wall Street fundraising, has officially come out in favor of gutting financial reform. The issue they've targeted: derivatives, the most closely watched effort of the bank overhaul. Good luck in November, guys.

New Democrats like to say they are "pro-business," but what they usually mean is, "willing to funnel federal gifts to bigwig executives." Their chair is Rep. Joseph Crowley, D-N.Y., currently under investigation by the House Office of Congressional Ethics over a fundraiser he held just days before the final House vote on the Wall Street reform package back in December 2009. Crowley is a favorite of Wall Street CEOs, who has pulled in more than $2.6 million from the finance industry over the course of his Congressional career, over 250 percent more than any other industry.

Crowley isn't the only New Dem close to Wall Street. Rep. Jim Himes of Connecticut is a former Goldman Sachs executive, Rep. Melissa Bean of Illinois has been doing big banks' dirty work for years, and New Dems score more campaign contributions from Wall Street than their regular-old-Democrat colleagues.

The new Dems are opposing the tough derivatives overhaul being pushed by Sen. Blanche Lincoln, D-Ark., known on Capitol Hill as "Section 716." The Lincoln plan is a huge blow to Wall Street profits and the first real crack in the too-big-to-fail armor worn by the nation's largest banks. The derivatives market is the risky casino that brought down AIG and Enron, and played a huge role in the inflation of the subprime mortgage bubble and necessitating the bailouts of megabanks when that bubble burst. While a little under ten percent of the market consists of risk-hedging by businesses, the remainder is a speculative nightmare.

Taxpayers actually subsidize this market by allowing commercial banks to deal derivatives. Since commercial banks have access to cheap Fed loans and FDIC-guaranteed deposits, this funding ends up feeding the global casino. If you force banks to move their derivatives operations to an independently capitalized subsidiary with no access to taxpayer perks, the market shrinks, and with it, big bank profits and bonuses.

But of course, bankers like their bonuses, and they've enlisted the New Dems to protect them. A total of 43 New Democrats are circulating a letter around Capitol Hill in an effort to defang the derivatives overhaul (interestingly, 26 New Dems have refused to sign on to this overt Wall Street sellout). Here's the key section:

"Section 716 . . . would increase systemic risk by forcing derivatives transactions into less regulated and less capitalized institutions and impede effective oversight of the derivatives markets . . . Legitimate conflict of interest concerns are addressed by the ban on proprietary trading in the Volcker rule, and, accordingly, we believe Section 716 should be removed from the legislation."

Nobody in Washington takes these claims seriously. One is a bald-faced lie, the other an effort to obfuscate other New Dem efforts to defang the Volcker Rule itself.

First, the lie. The New Dems are claiming that the Lincoln provision would push derivatives into the shadows, when, in fact, it would bring them into the light. Right now, most derivatives transactions are conducted off-balance-sheet, meaning banks don't have to disclose information about these risky deals to their investors, making it easy for them to skirt capital requirements. The idea that the Lincoln plan could actually make the derivatives market more opaque or harder to regulate than they are now is just laughable.

The Wall Street reform bill includes a set of capital rules for all derivatives trading, rules which apply to everybody who engages in derivatives activity, be they a hedge fund, a bank, or a bank-affiliate. There is absolutely no way in which Lincoln's plan would be "forcing derivatives transactions into less regulated and less capitalized institutions."

The opposite, in fact, would happen. Banks would have to put up more of their own money in order to back derivatives trades, because they wouldn't have access to taxpayer money to back them. That's why the bank lobby is fighting the Lincoln language like crazy.

The bank lobby has been pushing for weeks to secure some kind of compromise in which the Volcker Rule is substituted for Lincoln's derivatives plan. There is almost no overlap between the two proposals. The Volcker Rule bans outright gambling by banks-- Lincoln's plan is an effort to rein in gambling outside of the banking system itself.

And New Dems are also making a huge push behind the scenes to gut the Volcker Rule. As Brian Beutler has reported, New Dems Dennis Moore, D-Kan., and Gregory Meeks, D-N.Y., are part of a team that hopes to secure a giant fatal loophole allowing banks to invest up to 5 percent of their capital in hedge funds. In other words, no gambling, except when you conduct this gambling with a hedge fund. This would totally gut the purpose of the Volcker Rule. Hedge fund investments have a habit of creating absolutely massive losses—even when the upfront investment is relatively low. In the go-go years of the housing bubble, Bear Stearns put $40 million into a hedge fund to gamble on mortgages. As Mike Konczal has emphasized, when that hedge fund blew up in 2007, Bear Stearns had to payout over $3.2 billion in losses—80 times what they put into it. If that $40 million had been 5 percent of Bear's capital, the company would have been bankrupt four times over when the hedge fund went down.

The New Dems are hoping that this overt hatchet-work for the bank lobby will simply go unnoticed in the media firestorm surrounding the BP oil catastrophe and General McChrystal's inability to understand chain-of-command under a Democratic commander-in-chief. Don't let them get away with it.

Will Wall Street Reform Be Gutted By A Technicality?

Zach Carter — Thu, 17 Jun 2010 18:24:20 -0400

The tough derivatives overhaul proposed by Sen. Blanche Lincoln, D-Ark., has emerged as the key fight in Wall Street reform. That status is well-deserved. Despite Lincoln's record as a stooge for corporate executives, she is pushing what is by far the most significant threat to the Wall Street bonus machine currently on the table. But what's not as well-known is that Lincoln's plan hinges on critical technicality elsewhere in the reform package that would thoroughly defang her plan if removed.

So far as the absurdly complex world of derivatives trading is concerned, the Lincoln bill is relatively straightforward: No more taxpayer subsidies for the crazy derivatives casino that brought down AIG and Enron. Taxpayers provide two key subsidies to the commercial banking system, namely cheap loans from the Federal Reserve's discount window, and deposit insurance. Deposit insurance protects the public from losing its money when a bank fails, but that guarantee means banks don't have to pay very much to win depositors' money, making them a very cheap source of funding. Since just a handful of commercial banks deal nearly $300 trillion in derivatives, those subsidies are a very big deal.

By eliminating taxpayer subsidies, Lincoln would force banks to raise more capital against their derivatives deals, which provides a cushion against losses, and prevents banks from overextending themselves on risky activities.

To kill off the subsidies, Lincoln's plan—known as "Section 716" on Capitol Hill—would force banks to move their derivatives dealing operations into an independently capitalized affiliate company. That affiliate would have no access to taxpayer perks, and would not be able to use cheap Fed loans and deposits to book artificially inflated profits—and by extension, bonuses—on inherently risky derivatives deals.

But for this plan to work, the bank—a company with access to taxpayer perks—can't be able to simply bail out its derivatives affiliate when it gets into trouble. Those bailouts would ultimately be financed by taxpayer subsidies, rendering the whole point of the Lincoln plan meaningless. There are already laws on the book that limit transactions between banks and their affiliates (for wonks: Sections 23A and 23B of the Federal Reserve Act), but the laws are weak. Fortunately, Section 608 of the Wall Street overhaul that cleared the Senate significantly strengthens those rules.

Current law only keeps banks from bailing out their affiliates with traditional loans. If they want to use a more complicated transaction, like, say, a derivative, to salvage the affiliate, they can. The Senate bill tightens this language, barring banks from bailing out their affiliates with both securities lending and derivatives operations.

This barrier isn't ironclad, but it is meaningful. Banks can still devote up to 10 percent of their capital to transactions with an affiliate firm, but no more. That number may sound high, but remember—even if banks continuously push out 10 percent of their capital to their new derivatives affiliate, which they would never do for various technical reasons, that's only one-tenth of what they're currently allowed to use. It'd be better if this number were, say, zero, but banks really will have to put up a lot more capital to deal in the derivatives casino if the Senate language survives.

Even more important, Section 608 requires affiliates to post collateral for any transaction they engage in with their bank. That means no free lunch for the derivatives affiliate if it gets into trouble. While banks can still make (limited) arrangements to save the derivatives affiliate, the affiliate has to put up something of equal value in exchange. In other words, the bank can't just bailout the derivatives house with taxpayer subsidies.

So watch Section 608 very closely as the conference committee on Wall Street reform reconvenes next week. With derivatives becoming the hot-button issue for the financial overhaul, very few lawmakers are interested in being caught publicly selling out to megabanks this late in the reform process, particularly with the November elections just a few months away. But they may very well gut a handful of less-well-publicized technical measures in an effort to gut the derivatives reform by proxy.

Real Reform Gains Traction: Lincoln Stands Firm on Derivatives Overhaul

Zach Carter — Thu, 17 Jun 2010 09:49:04 -0400

As the House and Senate publicly iron out their differences on Wall Street reform during conference committee, the most important aspect of the overhaul is gaining strength behind the scenes. Sen. Blanche Lincoln, D-Ark., is standing firm on her tough derivatives bill, and continues to garner unlikely allies from within the Federal Reserve as the final vote on the provision approaches.

The latest high-profile supporter of Lincoln's bill is St. Louis Fed President James Bullard, according to a Senate source familiar with the matter. Bullard joins Kansas City Fed President Thomas Hoenig and Dallas Fed President Richard Fisher as recent co-supporters of the measure to rein in megabank derivatives operations. Other key members of the conference committee, including House Agriculture Committee Chair Collin Peterson, D-N.D., are also offering support for the provision, which is likely to come up for a vote next week.

Both the bank lobby and reformists recognize that Lincoln's effort—known on Capitol Hill as Section 716—is the most serious proposal to rein in Wall Street still on the table for 2010. The bill's strategy is simple: End taxpayer subsidies for the derivatives market—the crazy casino that brought down AIG, Enron and Long-Term Capital Management. Right now, five megabanks score enormous profits by backing their derivatives operations with cheap loans from the Fed's discount window and taxpayer-guaranteed deposits. This cheap funding makes derivatives enormously profitable, and encourages banks to fuel enormous speculative casinos. Speculation on that magnitude is inherently unstable, and when the casino comes crashing down, the result is a disaster for the global economy (think AIG and Lehman Brothers).

By forcing banks to move their derivatives dealing into separately capitalized affiliates with no access to taxpayer perks, the business would become less profitable, and the global capital markets casino would shrink, putting the broader economy on stable footing.

But since those taxpayer subsidies mean big profits for banks, they also mean big bonuses for bank executives. And so every Wall Street lobbyist in Washington has been targeting Section 716, and they've convinced some top-level, bank-friendly officials like Fed Chairman Ben Bernanke and Treasury Secretary Timothy Geithner to defend them.

But lately the political wind has shifted to Lincoln's back. Former Fed Chairman Paul Volcker, previously an opponent of the provision, reversed his opposition, saying he hadn't fully understood the details of the plan. A host of high-profile economists, including Nobel Laureate Joseph Stiglitz, former IMF Chief Economist Simon Johnson, Nouriel Roubini, Robert Johnson, Jane D'Arista and others have endorsed 716, saying that it's the last best chance to end Wall Street's reliance on taxpayer bailouts.

Derivatives are the central way that megabanks make themselves too-big-to-fail. By engaging in hundreds of millions of dollars worth of derivatives trades every day, banks enshroud themselves in complex webs of debt that no regulator can decipher. If a bank like that finds itself on the verge of collapse, regulators simply cannot predict what will happen if the bank is shut down. The Wall Street reform bill includes expanded authorities for regulators to shut down failing financial titans—but regulators will not use those powers on banks that run derivatives casinos on the scale of those currently in existence, in which five banks control nearly $300 trillion in trading. That's trillion, with a 't.'

Lincoln made a few concessions earlier this week in an effort to appease critics, but so far, none of them have been important. The most significant move will allow the Fed to provide derivatives dealers with emergency funding in the event of a financial collapse—powers known in Washington as 13(3) authorities. For many reform advocates, this looked sinister—the point of the Lincoln language is to remove taxpayer subsidies, but Lincoln would now permit emergency Fed loans.

This is ultimately a non-issue. The point of Lincoln's overhaul is to end the situation in which banks fund derivatives operations with loans from the Federal Reserve's discount window and cheap taxpayer-backed deposits. Discount window lending is radically different from the kind of lending the Fed does under 13(3). Banks go to the discount window all the time for loans as part of the ordinary course of business, and those loans come with a low, predictable interest rate (currently 0 percent). Lending under 13(3), by contrast, comes with strings attached. For all the faults of the Fed's handling of the AIG bailout, the Fed received an 80 percent stake in the company and discharged the firm's CEO.

This is not the sort of help that derivatives dealers want from the government—what they want are low-interest-rate loans from the Fed, and cheap FDIC-insured deposits. The prospect of emergency Fed lending doesn't change the incentives for a derivatives dealer any more than the prospect of some future Congress enacting a new law authorizing broad bailouts of derivatives dealers does.

Without access to discount window loans or FDIC-insured deposits, banks simply cannot operate. Even with access to emergency Fed lending, banks will have no choice but to move their derivatives dealing operations into an independently capitalized affiliate, and that affiliate will not be able to fund derivatives with cheap taxpayer guarantees as part of the basic business model. As soon as those operations are pushed out, banks will immediately have to put more capital behind them, and the entire derivatives casino will shrink. The reform is still fully intact.

No law can ban future bailouts, whether they be from the Fed or Congress. When the next financial crisis hits, policymakers will bail out whatever firms they deem necessary to prevent a collapse. If they need to change the law, they'll go to Congress. If Congress spurns them, policymakers will conduct their bailouts under-the-table by letting firms get away with overly optimistic accounting. What we can do is limit the potential for that next crisis to ever come about. Lincoln's plan is the most important provision for preventing a future crisis still on the table.

Commodity Futures Trading Commission Chairman Gary Gensler was one of the chief advocates for allowing 13(3) funding to derivatives dealers, according to a Senate source familiar with the negotiations. Gensler is the most serious advocate for derivatives reform in Washington, and he has been instrumental in pushing to fix another major loophole in the regulations requiring central clearing of derivatives (the current bill doesn't allow regulators to enforce those regulations, and Gensler has come out strongly in favor of fixing the problem during the conference committee).

The fight for Lincoln's bill is by no means over. The endorsement of three Fed presidents comes as a coalition of Wall Street-friendly New Democrats, led by Reps. Melissa Bean, D-Ill., Joe Crowley, D-N.Y., and Jim Himes, D-Conn., push back against the Lincoln language. The New Dems argue that 716 can be replaced by a strong Volcker Rule, which bans speculative gambling by commercial banks. The argument is totally disingenuous—the Lincoln plan is about limiting speculation throughout the financial sector, not just in banks themselves.

So far, neither Treasury nor the New Dems have had much luck persuading members of the conference committee to buck 716. Almost nobody in Washington wants to be caught committing an epic sell-out to Wall Street during the final stages of the reform process, when the public is watching every move. We've known for several weeks that some version of Wall Street reform would ultimately pass Congress. If Lincoln holds firm, that reform will actually be significant.