Endgame on Financial Regulation

Harry Reid has now filed a cloture motion to end debate on the financial overhaul bill, which means a final vote could come Wednesday or Thursday. Or not. With the Senate, you never know.

There are at least a half-dozen important amendments that will be voted before the final curtain, and I would urge people to call or email wavering senators. But one of the most easily confused battles will be about tough new prohibitions on derivatives trading by banks and bank holding companies. This would be a baffling topic under the best of circumstances, but Democrats have made it even more so by throwing up two similar-sounding proposals that are wildly different. To be blunt: one of those proposals is a really good idea, while the other one is a really dumb idea.

Financial derivatives played a big role in turning the collapse of subprime mortgages into a global financial collapse. Credit-default swaps tied to subprime mortgages were at the heart of AIG’s immense collapse, and they fueled an immense casino of highly-leveraged bets that all went south at the same time when the housing market tanked. Credit-default swaps amplified reckless behavior because they allowed bond investors to think they had insurance against bond defaults. They also became a multi-trillion-dollar game in themselves, with hedge funds and other institutions buying up swaps even when they didn’t own the underlying bonds. None of this was regulated.

The Senate bill, like the previously-passed House bill, would subject derivatives to a lot more regulation and transparency. It doesn’t go as far as many reformers would like, but it’s a start.

But now the Senate will be weighing two more radical proposals. The good one is from Senator Jeff Merkley (D-OR) and Sen Carl Levin (D-Mich). It would prohibit banks and bank holding companies, which have federally-insured deposits, from engaging in proprietary trading in stocks, bonds and derivatives.

This is a tough version of the so-called Volcker Rule, first championed by former Fed chairman Paul Volcker and somewhat belatedly supported by President Obama and the White House. As currently written, the Senate bill tamps down the Volcker rule by merely instructing regulators to study a ban. Merkley-Levin would impose the ban straighaway.

The banks are lobbying frantically against the amendment, because prop trading has provided a huge share of profits at Goldman, JPMorgan Chase and many other banks. Senate Republicans are now threatening to filibuster the issue, which would mean Democrats would need 60 votes rather than 51.

But the Merkley-Levin proposal makes perfect sense: prop trading is risky, and banks get special govt protection. The public gets no benefit whatsoever from the fact that banks roll the dice for their own accounts, but it is exposed to the downside risks in the event of another “once in a century” financial calamity that “nobody” saw coming. Remember: just because banks can’t make as much money doesn’t mean it’s bad for America. And remember: Goldman Sachs and probably countless other firms were actively betting against some of the very same subprime mortgage products they were creating an d selling. If the banks exit trading, others will undoubtedly step in to take their place. The market, like nature, abhors a vacuum.

There’s a lot of squawking from financial lobbyists about the difficulty in distinguishing “proprietary trading” and “market-making” for the benefit of financial customers. This is a red herring. It’s true that banks have to hold positions and counter-positions if they want to serve as market-makers and provide liquidity for a market. But there are all kinds of ways to draw a bright line, and regulators won’t have much trouble.

Unfortunately, the Dems have a second proposal — Senator Blanche Lincoln of Arkansas’ flat-out bank on all swaps activities by banks and other insured depository institutions. Lincoln, who faces a tough primary election Tuesday and is in danger of losing, is a centrist/conservative Dem who could barely make up her mind on the Democratic health care bill and is now trying to prevent a backlash from liberals.

But Lincoln’s proposal, approved by the Senate Agriculture Committee and incorporated as Section 716 in the Dodd bill, would actually make banks more dangerous by prohibiting them from hedging the normal risks that are at the heart of their business. When banks make fixed-rate loans,they often use interest-rate swaps to hedge against interest-rate risk. It’s a sensible strategy, and exactly the kind of thing derivatives are supposed to do. Without hedging, the cost of fixed-rate loans would inevitably be higher. So would a all kinds of other financial transactions.

That’s why a wide range of experts, starting with Paul Volcker, are against Lincoln’s provision. Lincoln and Dodd have both signaled they are open to compromises on the measure, and the betting has been that senior Democrats are simply waiting until the Arkansas primary is over on Tuesday before they tamp it down. But that may be too clever by half.

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