Blanche Lincoln Throws the Banks a Derivatives Curve Ball

How did the bankers miss this one? It appears as if Senator Blanche Lincoln and the Senate Agriculture Committee are on the cusp of passing derivatives reforms that would be somewhat akin to driving a stake through a vampire’s chest.

As the Wall Street Journal is reporting, the banks are in full lobbying mode but it may be too late.

Wall Street giants Goldman Sachs Group Inc., J.P. Morgan Chase & Co., and Morgan Stanley have launched a last-ditch effort in Congress to fight changes to financial regulation that would squeeze their lucrative derivatives-trading businesses.

But the bankers’ efforts appear to be faltering in the face of strong pressure on key congressional Democrats from the Obama administration. That’s drawing Republican complaints that the pending rewrite of the rules of finance will put the economy at risk.

Maybe I just spaced what was going on with Lincoln, but her plan certainly does seem to have taken a lot of people by surprise. As described by Politico, the plan has some provisions that definitely are going to have the regulate them until they scream crowd cheering.

— first, Lincoln will propose regulating foreign currency swaps, an action even the Treasury Department has opposed;

— second, Lincoln would bar any “major swaps dealers,” including big banks, from receiving federal financial assistance in the event of a market meltdown;

— third, the Arkansas Democrat would require dealers to consider their “fiduciary duty” to all governmental agencies, pension plans, endowments or retirement funds during any transaction;

— and fourth, swaps dealers or other traders in the complex financial instruments would be open to fraud actions brought by federal government, if they engage in a transaction with another party knowing the deal could be used to defraud other investors or the public.

Politico suggests that the provision barring federal support for swaps dealers would cause the big banks to spin off their swaps desks to subsidiaries in order to continue to qualify for FDIC insurance and to receive funds from the Fed. Their analysis is that in the event of a future crisis, these subsidiaries would not receive government support and would be allowed to fail.

They may indeed have to separate their swaps operations if the legislation passes as proposed but the idea that those operations would not be rescued in the event of a major catastrophe is a stretch. If we’ve learned anything it’s that in the lurch the banks get bailed out. So, I wouldn’t invest a great deal of trust in the idea that this particular proposal is going to insulate the taxpayer from future liabilities.

Lincoln’s plan pushes most derivative trading onto exchanges or into clearing houses. I don’t have much of a problem with that, in fact it’s probably long overdue. I think that including foreign currency instruments in the plan is wrong and the language about fraud and fiduciary duty only open one more door for the lawyers to slither through but maybe some truly sensible and real reform can come from her proposals.

The fact that the banks appear to be in full opposition mode suggests that this one would hurt, mostly in their pocketbooks. It makes one wonder if the talk about transparency and price disclosure that would come from clearing these transactions on central exchanges might not have some validity. A little less flexibility might be a small price to pay for more competition and lower transaction costs in the derivatives market.

So, I find myself in a camp I don’t often visit. I wish Lincoln luck with her proposals and hope that Congress can actually hammer out some reasonable reforms to a market that probably is much too big, opaque and risky.

ADDENDUM: Economics Of Contempt has an excellent post that questions the amount of safety that a clearinghouse might afford the derivatives market. I recommend you read it as well as the excellent comments that follow the post if you have a deeper interest in the subject.

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