On the Influence of Wall Street in Congress: The Proposal to Distinguish Financial and Commercial Derivatives

In the process whereby financial reform legislation made its way through Congress after the financial crisis of 2008, the U.S. House and Senate had different approaches concerning who would be required to go through a clearing house to buy or sell deriviative securities. According to Michael Masters, "The clearing house would stand in the middle of the transaction and guarantee both sides of the trade. If one counterparty to the transaction fails, then the central counterparty absorbs those losses, protecting the system as a whole from collapse."  Masters claims that "Wall Street firms hate this idea because their prodigious profits will dwindle when derivatives are traded in the light of day, letting their counterparties see the true costs. So Wall Street is pushing hard to exempt as many transactions as possible."  Given the culpability of Wall Street in the financial crisis, they were in no position to "push hard." That they did nonetheless is a telling sign of the underlying character, or lack thereof, "on the street."  Furthermore, that the representatives and senators were listening to them ought to cause the voters some concern.  Yet because of the reality of the banks' muscle on the hill, the power of the banks to exploit any loopholes in the final legislation should have been salient as the legislation made its way through Congress. This can be seen in whether to favor the House or Senate version.

According to Masters, "The Senate version of the clearing house requirement, which is currently the base text for the bill, includes a narrow, well-defined exemption that allows commercial end-users a complete exemption from clearing, while denying this exemption to financial players. The House language, however, would exempt anyone hedging "balance sheet risk." Since every financial player has a balance sheet, it is estimated that more than 50% of the outstanding derivatives would go uncleared under the House plan, compared to just 10% under the Senate version."  One might say: Ah, 50% is a pretty wide door--better go with the Senate version (assuming it could resist threats and favors from the banking lobby).

Masters explains the rationale for the Senate's version. There "is a critical policy distinction that must be made between commercial end-users like airlines, and financial entities like hedge funds. For a commercial end-user, risk arises naturally out of the ordinary conduct of business. For a financial entity, pricing and managing risk is their core business. As an example, an airline cannot fly without incurring the risk of wildly gyrating jet fuel prices. Allowing them to hedge their jet fuel exposure without a clearing requirement would provide stability for the airline, confidence for airline investors and ensure that the broad U.S. economy benefits from reliable airline service. A hedge fund, however, starts with no inherent risk. Its mission is to evaluate investment options, balancing risk and reward. If a hedge fund enters into a jet fuel derivatives contract on a bet that prices will increase, then it's nonsense to say that they are "hedging" when they subsequently enter into an offsetting deal to reduce the risk they voluntarily took on in the first place. These semantic charades can easily be carried to such extremes that every transaction a hedge fund enters is "hedging" something. An exemption for hedge funds serves no social purpose and, in fact, it puts our entire financial system at risk."  In other words, there are good business reasons for non-financial companies to be able to use derivatives to hedge for risk related to price volitility even if the companies cannot meet the clearing requirements. Of course, it could be asked what proportion of commercial use should but would not occur were such use subject to the clearing house requirements.  I don't know the answer to this question. I contend, however, that even if it is significant, the danger that the loophole would be exploited such that the financial system would once again be at risk outweighs any such inconvenience.  In other words, in reaching too far for perfect efficiency, we could unwittingly be inviting the irrational exuberance of the market to destroy the market mechanism itself.  We ought not fly too close to the sun or we might get burnt and fall to the ground. Masters concludes that the Senate language is "superior to the House's simply because it forces far more derivatives into the open." This may be so, but what would prevent a financial player from using a commercial user as a front to bypass the clearing requirements? Furthermore, there might be legislative language in the exemption that allows financial firms to obviate the clearing houses without even needing such a front.

In short, I contend that having any loopholes, or exeptions, is an unwise practice when we know (as Sen. Dick Durbin said) that the banking lobby owns Congress. We also know that managers and their lawyers are oriented to exploiting loopholes.  To expect otherwise is to tell a shark that it should not be a feeding machine.  That is, we must accept the nature of business for what it is, and not do what can reasonably be assumed to be taken advantage of.  It is like saying to sharks: those of you who do not eat any swimmers can go through the hole in the net and into the shore area.  It is just too dangerous to have a hole in the first place, even if there are some benefits to having it.

Source: http://money.cnn.com/2010/06/23/news/economy/congress_derivatives/index.htm

Making Too Big To Fail Costlier: A Check on Empire-Building

Testifying before the Financial Crisis Inquiry Commission on September 2, 2010, Ben Bernanke, chairman of the Federal Reserve, observed, “As of 2003 and 2004, there really was quite a bit of disagreement among economists about whether there was a bubble, how big it was, whether it was a local or a national bubble. We certainly were aware it was a risk factor, but frankly by the time it was clear it was a bubble” it was too late to address it through monetary policy. The New York Times also reported that he spoke favorably of forcing huge banks to hold much more capital, particularly if they were systemically important — so much capital, indeed, that being big would be costly. He advocated that the increased capital requirements should include capital that is more aligned with risk and able to absorb losses more effectively, and that works in a countercyclical manner, so that banks have more of it during times of stress.
Given the difficulty involved in recognizing a bubble even as it crests, Bernanke’s statements on capital-holding changes make sense. Absent breaking up banks too big to fail, making it very costly for them to be big is the next best option. The regulators would be wise to be on the look out, however, for bankers who try to hide their banks’ true sizes (and risk). Given the empire-building proclivity in the business world, designing a system that makes bigness more costly could result in an overall balance of forces. The key is to make being big sufficiently costly that the drive to empire-build is sufficiently checked in the banks.

Source: http://www.nytimes.com/2010/09/03/business/03commission.html?_r=1&ref=business

Financial Sector Lobbyists Put the Republic at Risk: The Case of the U.S. Senate Bill on Financial Reform in 2010

Considering the gravity of the risk in Wall Street banks being too big to fail, the financial reform bill passed by the US Senate in 2010 may have been influenced too much by the financial interests. It can thus serve as a good case study for how a republic can be subject to too much influence from the moneyed interests. It could be asked, moreover, whether there is an inevitable trajectory that a polity undergoes from being a republic to becoming a plutocracy (ruled by the wealthy).

Executives and political action committees from Wall Street banks, hedge funds, insurance companies and related financial sectors showered Congressional candidates with more than $1.7 billion in the last decade, with much of it going to the financial committees that oversee the industry’s operations. In the 2010 election cycle before the financial reform bill passed the Senate, members of the financial committees far outpaced those of other committees in fund-raising parties by holding 845 events. The 14 freshmen who serve on the House Financial Services Committee raised 56 percent more in campaign contributions than other freshmen. And most freshmen on the panel, the analysis found, are now in competitive re-election fights. In return, the financial sector has enjoyed virtually front-door access and what critics say is often favorable treatment from many lawmakers. But that relationship, advantageous to both sides for many years, is now being tested in ways rarely seen, as the nation’s major financial firms seek to call in their political chits to stem regulatory changes they believe will hurt their business.

Even after the passage of the Senate’s bill, the financial industry was confident that a provision that would force banks to spin off their derivatives businesses would be stripped out, but in the final rush to pass the bill, that did not happen. The opposition came not just from the financial industry. The chairman of the Federal Reserve and other senior banking regulators opposed the provision, and top Obama administration officials said they would continue to push for it to be removed. Such officials could include Larry Summers, who along with Alan Greenspan and Robert Rubin pushed for derivatives to be left unregulated in the late 1990s while Summers and Rubin were in the Clinton Administration.

Not missing a beat, Wall Street lobbyists  began an 11th-hour effort to remove it just as House and Senate conferees were preparing to meet to reconcile their two bills. Lobbyists said they were already considering the possible makeup of the conference panel to focus on office visits and potential fund-raising.  Rep. Barney Franks, chairman of the House Financial Services Committee, signaled on May 25th that the prohibition on banks trading in deriviates using their own funds could be dropped. “I don’t see the need for a separate rule regarding derivatives because the restriction on banks engaging in proprietary activities would apply to derivatives as well as everything else,” Mr. Frank said according to The Wall Street Journal (May 22, 2010, p. A6).  However, if this were the case, why would Sen. Dodd, the White House, and the banks be so set against removing the derivative langauge?  Is redundancy really that big of a deal?  Something is rotten here; I can smell it. With Sen. Dodd retiring, I wouldn’t be surprise if he made a deal with Wall Street concerning his financial future–it being so odd how he has mellowed so much on reform. Not surprisingly, the Chamber of Commerce had already spent more than $3 million to lobby against parts of the bill, including the derivative provision, and as the Senate was passing its bill the Chamber was planning to keep fighting for a loosening of the regulatory restrictions — first in the House-Senate conference, then in the implementation phase after final passage of a bill, and “if all else fails,” in court. With all these avenues, it is no wonder that the money of Wall Street banks has such ease in Washington.

There are so many points along the line of a bill becoming a law that a provision with teeth can be targeted by well-funded parties with a vested interest against it, it would appear that no change can happen in the US that is not in an industry’s interest.  Because wealthy firms have presumably done ok under the status quo, it is not clear why they would have an interest is supporting systemic change even if systemic risk warrants it. In the case of financial reform,the financial houses have a rather obvious conflict of interest. Furthermore, the behavior of the big bankers in September of 2008 suggests that they do not view rescuing a financial system in crisis as their job.  There is no reason to suppose that the legislation that they support would be geared to repairing the system when it is in crisis. The real problem is apt to manifest on the crest of the next bubble, as the industry had already gotten much of what it wanted even with the derivatives language in the Senate bill.

According to The New York Times, “Despite the outcry from lobbyists and warnings from conservative Republicans that the legislation will choke economic growth, bankers and many analysts think that the bill approved by the Senate … will reduce Wall Street’s profits but leave its size and power largely intact. Industry officials are also hopeful that several of the most punitive provisions can be softened before it is signed into law.”  This is dangerous because so many bankers, including those at Goldman Sachs, have been in denial as to how they should behave.  According to The Wall Street Journal, Bank of America, Deutsche Bank, and Citigroup have continued their practices of “window-dressing”: temporarily shedding debt just before reporting their finances to the public. This suggests that “the banks are carrying more risk most of the time than their investors or customers can easily see.”   As of 2010, this activity had actually increased since 2008, “when the financial crisis brought actions like these under greater scrutiny.”  For ten quarters ending March 2010, the three banks lowered their net borrowings in the repo market by an average of 41% at the end of the quarters (as compared with during them). This represents a significant misstatement, which the banks’ auditors should have highlighted. The Wall Street Journal reported in April 2010 that 18 large banks, as a group, had routinely reduced their short-term borrowings in this way.

So it appears that Wall Street went on in its old ways even after the crisis, and there was relief that financial reform would not rock the boat. According to The New York Times, “If you talk to anyone privately, there’s a sigh of relief,” said one veteran investment banker who insisted on anonymity because of the delicacy of the issue. “It’ll crimp the profit pool initially by 15 or 20 percent and increase oversight and compliance costs, but there’s no breakup of any institution or onerous new taxes.” In other words, incrementalism rather than systemic change.  Washington, in other words, had been bought–even the “real change” agent himself, Barak Obama.  Mr. Obama is not unaware of the powerful friends he will need in 2012. He received just under a million dollars from Goldman Sachs for his 2008 campaign.  How difficult it is to let go of power, and say that one term will be enough, even better, for that is what seems to be necessary for one to fight against the entrenched culprits of the status quo.  In actuality, Andrew Jackson showed in 1832 that standing up to a large bank (in his case, the Second Bank of the US) can actually be consistent with winning reelection.  But absent such faith in the people to come through, saying to hell with reelection seems to be necessary for a president to be an authentic agent of real change.  If anything called for such change, it was the financial crisis of 2008. Yet as the House and Senate compared notes on their respective bills, Wall Street was actually relieved.  That really says something.  The culprits have an effective veto on what safeguards will be put in place to keep the banks from risking the world economy again. The wolves have to accede to the design of the new chicken coop. To my fellow Americans, I say: this is our system.

Even though the financial crisis far outweighed any health-care crisis, the financial reform is far more incremental–though both are within that rubric. “The health care bill is going to transform the structure of health care exponentially more than this legislation on financial regulation is going to change Wall Street,” said Roger C. Altman, the chairman of Evercore Partners and deputy Treasury secretary in the Clinton administration. “It’s not even close.”  It could be that the added incrementalism in the health-care legislation was in the interest of the health insurance companies and hospitals, whereas less was in the interest of Wall Street.

Of course, it could be that regardless of the regulation, financial bubbles are bound to come and go, and the sheer scale of financial deals today requires large banks. Donald B. Marron, the former chief executive of Paine Webber, avers, “Despite these new rules, Wall Street will continue to provide the same important business services because the same needs are still there — creating liquidity; financing governments, corporations and individuals; and providing financial advice and products.” So perhaps the financial leverage of Wall Street in Washington doesn’t keep us from achieving a solution because the financial markets and their players are going along a trajectory that is being defined by the progression of the financial market.  Consider, for example, the pressure on banks from globalization to amass more and more capital for bigger and bigger deals.  In other words, the “too big to fail” phenomenon could be a necessary part of an increasingly globalized financial market.  Of course, this could point to the need for greater international financial regulation.  But with Europe embroiled with a debt crisis of its own and China wearily watching its own housing bubble, there were at the time of the passage of the Senate’s bill more financial bush-fires in the world than firemen.  The problem is that the fire chiefs are too often paid off (and intimidated) by the profiteering arsonists, so we are left woefully unprotected even if the veneer of regulatory reform has the looks of an effective profilactic.

Sources:  http://www.nytimes.com/2010/05/23/us/politics/23lobby.html?scp=2&sq=financial%20lobbying&st=cse ; http://www.nytimes.com/2010/05/24/business/24reform.html?hp ; WSJ (May 26, 2010).