The most courageous vote yesterday in the Senate was cast by Sen. Maria Cantwell, D-Wash., who refused to let the Senate sign-off on an unnecessarily weak Wall Street reform bill. Cantwell has been trying to fix a fatal loophole in the derivatives language which prevents regulators from enforcing new rules on the secretive shadow markets that brought down AIG. So far, the Democratic leadership has sided with the banks against Cantwell.
Here’s the basic problem. When Sens. Chris Dodd, D-Conn., and Blanche Lincoln, D-Ark., combined their derivatives bills in April, they cut language from Lincoln’s bill that would have made it illegal for banks to break the new derivatives regulations. As a result, the bill does a pretty good job listing activities that banks cannot engage in, but if banks simply decide not to follow the rules, regulators will not be able to crack down on them.
These problems were first reported in a story I wrote for AlterNet in April. Since then, HuffPost’s Shahien Nasiripour has elaborated on the matter, and both Mike Konczal and David Dayen have explained the issue in detail. I have also spoken about the conundrum with Laura Flanders begin_of_the_skype_highlighting end_of_the_skype_highlighting on GRITtv. Sen. Cantwell has an amendment that would close this loophole and make it an explicit violation of law for anyone to break the new derivatives rules Congress will enact. But for some reason, Dodd and Senate Majority Leader Harry Reid, D-Nev., have prevented that amendment from coming up for a vote on the Senate floor.
This is a separate, and much more fundamental fight than the contest between Dodd and Lincoln over whether banks will have to spin-off their derivatives businesses—which Dodd also appears to be hellbent on gutting. The spin-off issue would require that any derivatives dealing operations be divorced from taxpayer guarantees that commercial banks benefit from. It’s a very important provision, but the loophole Cantwell wants to close has to do with the basic functioning of the derivatives market—regardless of which firms operate as dealers. Without Cantwell’s amendment, Lincoln’s spin-off language is rendered meaningless.
Make no mistake, derivatives are the central fight in Wall Street reform. The debate over the Volcker Rule in large part hinges over the proposal’s impact on derivatives trades. The market amounts to hundreds of trillions—trillions with a “t”—in bets on anything you can dream up. These trades occur totally in the dark, without either market or regulatory supervision, making the derivatives market a hotbed for fraud and abuse, as evidenced by the Securities and Exchange Commission’s fraud suit against Goldman Sachs. The subprime mortgage nightmare simply could not have expanded to its disastrous scope without the derivatives market, which allowed banks and hedge funds to bet on lousy mortgages. Nobody knows what underlying assets will spark the next epic financial crisis—this time around it was housing– but if derivatives are not reined in, they will be used wreak havoc on the broader economy.
Wall Street banks make billions of dollars every year from keeping this business in the shadows. J.P. Morgan Chase alone thinks that bringing the market out of the shadows will cost it up to $2 billion in annual profits.
The central problem is the secretive nature of the derivatives market. When banks want to execute a trade, they just call each other up and agree to it, and the trade is finished. Nobody in the market has to sign-off on their ability to make good on these bets, and no regulator can look out for abusive or reckless trading. The minimum reform necessary would require a third-party to guarantee the bets that each side of the trade makes. When Bank of America bets with AIG, this third-party not only verifies that each company can make good on their side of the contract, this third-party agrees to pay in case one side does not follow-through on their obligation. This process is called “central clearing,” and the third party is known as a “clearinghouse.”
Central clearing prevents the cascade of defaults that policymakers were worried about when AIG went down in 2008. Once it became clear that AIG couldn’t make good on its derivatives bets, there was a major worry that dozens of other banks would take serious hits, collapse, and cause dozens of other collapses in the process. If we have a clearinghouse intermediating all derivatives trades, it will be the clearinghouse, not taxpayers, who are on the hook when derivatives bets go bad.
The current reform bill contains a host of good central clearing requirements, but if Cantwell’s amendment is not adopted, regulators will not be able to enforce those rules.
This is not a matter of liberal or conservative dispute. Every serious student of Wall Street reform, from Republican Treasury Secretary Henry Paulson to President Obama to socialist Sen. Bernie Sanders of Vermont, believes that central clearing is absolutely necessary to prevent the insanity we saw in 2008. All Cantwell wants to do is actually enforce those rules. She is absolutely right to withhold her vote for the bill until it meets this very low minimum standard. Dodd and Reid may be able to steamroll her by winning over Republican Scott Brown of Massachusetts. That would be a political victory for the Democratic leadership, and a major defeat for our economy.