Blowing a Hole in Dodd-Frank

Treasury Secretary Timothy Geithner is close to a decision to exempt the $4 trillion-a-day foreign-currency market from key provisions of the Dodd-Frank Act requiring greater transparency in the trading of derivatives. In the horse-trading over the final conference version of that legislation last year, both Geithner and financial-industry executives lobbied extensively to give the Treasury secretary the right to create this loophole. As the practical reach of Dodd-Frank is defined by the executive branch, this will be the first major decision to signal whether regulators will act to strengthen or weaken the reforms.

Update: Treasury Deputy Assistant Secretary Steve Adamske, after reading our story, said, "This in no way diminishes our commitment to enforce the rest of Title VII," [regulating derivatives], in effect confirming that a decision from Geithner to grant the foreign exchange exemption is imminent.

Geithner has already made his own views clear. In testimony before the Senate Agricultural Committee in December 2009, he declared that the foreign-exchange market needed no special regulation. "The FX [foreign exchange] markets are different," he said. "They are not really derivative in a sense, and they don't present the same sort of risk, and there is an elaborate framework in place already to limit settlement risk."

Geithner added, "These markets actually work quite well. We have a basic obligation to do no harm, to make sure that as we reform, we don't make things worse and our judgment is because of the protection that already exists in these foreign-exchange markets and because they are different from derivatives, have different risks and require different solutions, they require a different approach." This week, Treasury spokesperson Steve Adamske told me that Geithner stands by those views.

However, previously confidential information recently made public by the Federal Reserve Board reveals that in the aftermath of the collapse of Lehman Brothers in September 2008, the Fed pumped in $5.4 trillion over a three-month period to keep the foreign-currency market from collapsing. The Fed's peak injection of dollars on any one day occurred on Oct. 22, 2008, when it reached $823 billion, according to a Wall Street watchdog group's, Better Markets, analysis of the Fed data release.

The extent of the massive intervention by the Federal Reserve is now public information only because the Sanders Amendment to Dodd-Frank, which passed the Senate 96-0 in 2010, required the Fed to disclose more details of its financial operations. The extent of the intervention is buried in a massive data dump released by the Fed last December and was recently analyzed by Better Markets. This finding was contained in a letter sent by Better Markets President Dennis Kelleher to Geithner on Feb. 25. In his letter, Kelleher wrote, "The data refute the claim that the foreign-exchange markets performed well during the financial crisis and thus should be exempt from regulation."

Sen. Maria Cantwell, one of the most effective advocates for strong derivatives regulation during the Dodd-Frank debates, says, "I can't believe the first decision the administration would make to carry out Dodd-Frank would be an anti-transparency decision. The idea that the foreign-exchange markets are not at risk is preposterous -- we now know that they required multitrillion-dollar bailouts. Anytime you have a lack of transparency, there is potential for abuse."

The connection between foreign commercial transactions and the use of derivatives works like this: If a European importer, say Lufthansa, needs dollars to purchase aircraft from Boeing, the importer will ask its bank to convert some euros to dollars. The bank or a partner institution will typically use a derivative, a currency "swap" or "forward," to prevent the exchange rate from worsening while the transaction is pending.

But in the aftermath of the Lehman Brothers collapse, trust broke down and traders stopped accepting each other's financial paper. Derivatives markets were on the verge of freezing up. Foreign companies suddenly could not get dollars from their bankers, and both turned to central banks. But when foreign central banks realized that they could not provide enough dollars, either, they arranged with the Federal Reserve for massive swaps of dollars for local currencies, so that central banks could temporarily take the place of private derivatives markets in currency trades. The Fed in effect underwrote trillions of dollars in currency exchanges. This extraordinary support continued into 2009.

In short, far from these derivatives markets working "quite well," as Geithner asserted, they required massive support by the world's central banks, and by the Federal Reserve in particular. Indeed, it was Geithner himself, in his former job as president of the New York Federal Reserve, who was responsible for the $5.4 trillion Fed rescue operation -- without which foreign-exchange markets would have collapsed.

Yet Geithner's draft of what became the Dodd-Frank Act, sent by the Treasury to Congress in August 2009, excluded foreign-currency swaps from the derivatives reforms. The final House and Senate versions of the bill did cover foreign-currency derivatives, however. But as a result of extensive lobbying by Geithner and the financial industry, the final law contained a sleeper provision allowing an exemption if the Treasury secretary issues a finding that foreign-exchange derivatives should be exempted in the public interest.

The financial lobby has urged that this right be exercised -- in language almost identical to Geithner's. The main industry lobbying group, the Securities Industry and Financial Markets Association, in its formal comments filed with the Treasury last Nov. 15 urging the exemption, began by quoting Geithner's "FX markets are different" assertion and added that the industry "position is entirely consistent with Secretary Geithner's statement." The National Association of Manufacturers, in its official comment letter of last Nov. 29, enthusiastically quoted at length from the Treasury's own "talking points" on why foreign-exchange derivatives should be not be covered.

As Geithner nears a decision on whether to exempt foreign-currency trades, the industry has redoubled its lobbying campaign. Between November 2010 and January 2011, according to Treasury records, Geithner and Assistant Treasury Secretary Mary Miller met with 37 senior executives of major financial institutions, including Citigroup, Morgan Stanley, Deutsche Bank, and Barclays -- and no representatives of public-interest or consumer groups.

Foreign-currency trades, nearly all using derivative instruments, accounted for an estimated 38 percent of total bank profits in the first three quarters of 2010, according to the Comptroller of the Currency. The five largest banks -- JPMorgan Chase, Goldman Sachs, Bank of America, Citibank, and Wells Fargo -- control fully 97 percent of this market. Professor Michael Greenberger of the University of Maryland puts foreign-exchange trading profits at 70 percent of derivatives earnings at Chase, Citi, and Bank of America. Not surprisingly, the banks and their trade associations have made exemption of foreign-exchange derivatives a top political and lobbying priority.

Abuse of derivatives was at the absolute center of the financial meltdown. The collateralized debt obligations that were built on pyramids of sketchy mortgages whose value collapsed were, of course, derivatives. The mortgages themselves had been converted into highly leveraged, artificial securities -- the essence of a derivative. So were the credit-default swaps that took down American International Group. With a derivative, a tiny amount of capital can control a much larger financial bet, and until the Dodd-Frank reforms, the derivatives were constructed and traded privately, with no regulator scrutiny. If such bets go wrong, massive losses ensue. And in a generalized loss of confidence, even well-capitalized institutions fail to accept each other's credits.

Lehman Brothers collapsed when other large institutions refused to lend it money. The bankruptcy proceeding of Lehman -- the one large financial institution that the Treasury refused to rescue in the carnage of September 2008 -- reveals that when Lehman went bust, it was the "counterparty" or guarantor of some 930,000 derivative contracts, including credit-default swaps, interest rate, foreign exchange, and energy swaps. When Lehman went down, the party on the other side of the transaction was left holding the bag, hence the need for massive Fed intervention.

Regulation of derivatives has engendered fiercely contested battles as far back as the Clinton administration, when the banks' widespread use of derivatives was just taking off. Brooksley Born, the Clinton-appointed former chair of the Commodity Futures Trading Commission, famously warned against abuses of derivatives in 1998. For that apostasy, she was ostracized and isolated by the famous trio of Alan Greenspan, Robert Rubin, and Larry Summers. Just to be sure that no future CFTC chair would ever try to regulate derivatives, in December 2000, Republican Sen. Phil Gramm, with bipartisan support, steered the Commodity Futures Modernization Act through a lame-duck Congress, with little debate or comprehension. The measure was a 262-page rider tacked on to an 11,000-page appropriations bill with one day's notice. That law prohibited the executive branch from regulating swaps, either as securities, insurance, or gambling. The bill was promoted both by Enron and by the opponents of Brooksley Born and Clinton administration officials who opposed derivatives regulation.

In short order, derivatives abuses led directly to the Enron scandal and later the larger subprime meltdown. By cornering the market in energy derivatives that it had created, Enron contrived artificial shortages in electricity and profited handsomely from the spikes in prices to consumers. Enron used the same kind of off-the-books accounting to hide its true risks as the big banks later did.

Wall Street banks also colluded with the Greek center-right government, which was in power from 2004 through 2009, to create special derivatives that allowed that government to disguise foreign borrowings that exceeded the European Union's debt limits. By committing itself to repay debts in foreign currencies via customized derivatives, the Greek government enriched Wall Street (which booked large profits on the deals) at the government's own expense. As a leading derivatives expert, Satyajit Das, wrote in the Financial Times, "The participant [Greece] receives a payment today that is repaid by the higher-than-market payments in the future. . . . Such arrangements provide funding for the sovereign borrower at significantly higher cost than traditional debt. The true cost to the borrower and profit to the [swaps dealer] is also not known, because of the absence of any requirement for detailed disclosure."

Dodd-Frank, which superseded the Commodity Futures Modernization Act of 2000, basically requires all derivatives to be traded on regulated exchanges or central clearing facilities, where they are subject to prohibitions against market manipulation and where regulators have enough data to detect patterns of abuse. Exchange trading and central clearing also ensures that traders have enough capital to cover the trade if a deal goes bad. (When AIG's bets went sour, it turned out that the company had no money set aside to compensate its customers.) By mandating "standardized" derivatives traded on exchanges, Dodd-Frank also brings transparency to financial markets, which means more competition, less price-gouging of customers, and hence, lower windfall profits for bankers.

By contrast, the industry prefers no regulatory snooping and to have customized derivatives traded privately "over the counter," where secrecy allows banks and their traders to book larger profits at the expense of customers. Because derivatives are very highly leveraged, they can also be a source of systemic risk as well as market manipulation and price-gouging.

The industry's current lobbying on the question of currency exchanges turns the logic of derivatives reform on its head. According to comments filed with the Treasury by the Securities Industry and Financial Markets Association, the requirement that foreign-currency derivatives be traded on exchanges of clearinghouses could concentrate the risk, because the exchange itself might go broke. But Dodd-Frank explicitly mandates adequate capital be set aside to cover such deals. SIFMA also contends that extensive Federal Reserve support for the broken foreign-exchange market during the crisis proved that the system worked and that the friendly Federal Reserve is a much better manager of the system than an independent regulator such as the CFTC.

Gary Gensler, chair of the CFTC, which has direct jurisdiction over derivatives, has sparred with both Geithner and the industry over whether to exempt any category of derivative. In an Aug. 17, 2009, letter to Tom Harkin and Saxby Chambliss, chair and ranking Republican on the Senate Agriculture Committee, Gensler wrote, "I believe the law must cover the entire [derivatives] marketplace without exception."

"The concern," he added, "is that these broad exclusions could enable swap dealers and participants to structure swap transactions to come within these foreign-exchange exclusions and thereby avoid regulation." In other words, this loophole would invite traders to artificially bring foreign currencies into other derivatives transactions in order to avoid the scrutiny of Dodd-Frank. If the Wall Street-Geithner view prevails, Gensler's jurisdiction to protect the public from abuses in derivatives would effectively evaporate.

In recent months, the financial press has reported new abuses in foreign-exchange transactions. Lawsuits by state pension funds and other investors, several of which involve whistle-blowers who formerly worked at banks, allege that major banks overcharged investors by tens of million of dollars in foreign-exchange transactions. Harry Markopolous, who first called attention to Bernard Madoff's Ponzi scheme, is assisting some of the whistle-blowers. In California, Florida, Illinois, Massachusetts, Tennessee, and Virginia, state attorneys general have launched probes, according to The Wall Street Journal.

The banks accused of improper overcharges in foreign-exchange transactions include State Street Bank and Bank of New York Mellon. In October, State Street paid $11.7 million to Washington state's investment fund to settle alleged overcharges on foreign-exchange transactions. Some of the nation's most sophisticated investors, including Black Rock, a huge private equity firm, and Fidelity Investments, the nation's largest mutual fund company, have complained that banks have taken advantage of their privileged position in currency trades to overcharge them. If the nation's most sophisticated private equity and mutual funds consider the process so opaque that the banks are gaming even them, there is no company or investor that the banks can't take advantage of.

Suppose, for example, a bank is executing a foreign-exchange trade on behalf of a customer, swapping dollars for yen. If the bank purchases for its own account the foreign currency at the day's most favorable rate and then charges the customer the day's least favorable rate, the bank can pocket the difference. The banks are not required to indicate the time of the currency trade, so there is no way for a customer or regulator to determine whether the bank is acting in the customer's interest or its own. With a derivative, the bank puts up only a tiny fraction of the full amount, so profits are multiplied accordingly.

As professor Greenberger, formerly a deputy to Brooksley Born, warned in a letter to the Treasury on Nov. 29, "If foreign exchange derivatives are excluded from the definition of a 'swap,' those derivatives transactions would not have to be cleared; nor would they be transparent to the market participants, thereby increasing costs for swap participants, which would then be passed on to the costs to consumers." Greenberger added, "If the present financial crisis taught us anything, it is that market transactions must be properly capitalized and that there must be a market pricing mechanism, i.e., clearing and exchange trading, that sets firm and readily accessible prices for what would otherwise be wholly opaque transactions priced by illusory mathematics, rather than the market itself."

Will Dodd-Frank turn out to be the landmark reform that was advertised? Or will banks return to business as usual? "It would be an absolute disaster to allow Wall Street to continue to gamble with trillions of dollars in foreign-exchange derivatives without strong regulations and oversight," says Bernie Sanders, whose amendment forced the disclosure of the Fed's unprecedented intervention to rescue currency trades. "The Fed and the Treasury Department gave 'too big to fail' banks and large corporations a multitrillion-dollar bailout because of the unbridled and unregulated greed and recklessness on Wall Street. Creating another loophole for Wall Street could lead to an even bigger bailout in the future and could cause serious damage to the economy."

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