Among the best things about the current financial reform bill from Sen. Chris Dodd are the strong measures to make derivatives less risky and more transparent. However, don't expect them to stay tough, as Dodd remains open to replacement language that might attract Republican votes. While he hopes the language will come from seemingly moribund negotiations between Sens. Jack Reed and Judd Gregg, there is another source of crappy reform to consider: Sen. Blanche Lincoln's Agriculture committee, which is drawing up its own language (it may debut as early as tomorrow) on the question of complex financial products. Benjy Sarlin reports:Lincoln has said she favors exemptions for certain "end users," a term for consumers who don't represent financial institutions. Many of these companies use derivatives to protect themselves against risk rather than buy them as speculative investments, the type that was so damaging in 2008, and a number of these companies are pushing to change the bill so that they won't be required to put up the assets to clear their derivative purchases."The basic story is that if you exempt end users you have created a loophole large enough to drive a truck through," Dean Baker, co-director of the Center for Economic and Policy Research, said. Take for example, Enron, an end-user that was not a financial institution but ended up costing investors billions of dollars after peddling energy-based derivatives that became worthless when it went under.
Thus far, we don't have a sense of what derivatives reforms Democratic leadership and the White House are willing to defend, but an increasingly appealing primary challenge from Bill Halter could keep Lincoln focused on maintaining the support of reform-minded Democrats, especially given strong union participation in the various financial reform coalitions.
In the meantime, some spin from the Lincoln camp provides a teachable moment. Two important concepts in derivatives reform are exchange trading and central clearing. Exchange trading means that all derivatives transactions take place in a transparent market, not dealt with solely between two companies. This helps protect from AIG-like situations where firms are not sure who in the market holds large amounts of risk. It also creates more efficient pricing. Lincoln, to her credit, has promised that there will be strong exchange requirement.
But it's central clearing that worries reformers. This means that a regulated institution stands between two parties in a derivatives deal to make sure that both parties are able to pay for their share of derivatives with real collateral and take responsibility in the event of a default. To draw on the AIG example again, this means that another institution would have been responsible for making sure that AIG had the necessary capital to pay off its derivatives contracts in the event of their default; in 2008, the American taxpayer played that role.
Lincoln has been far less clear about what she plans to do with exemptions that would allow certain companies to buy and sell derivatives without clearing them first. This is an equally dangerous loophole, and it's where journalists and voters should pay a lot of attention. Even if the legislation manages to get all derivatives onto the exchanges, which will be a battle in and of itself, it should ensure that any exemptions to clearing are very tightly drawn. Don't let Lincoln's focus on exchange trading distract you from that key point.
-- Tim Fernholz
