Senators grapple with derivatives rules in financial overhaul
Senators hoping to pass a sweeping overhaul of financial regulations this week are frantically trying to resolve tough — and controversial — provisions limiting, regulating and shedding light on the largely hidden world of complex investments known as derivatives.
Senate Banking Committee Chairman Christopher J. Dodd (D-Conn.) introduced a last-minute compromise Tuesday that would approve, but hold in abeyance for two years, a proposed ban on banks’ engaging in nearly all derivatives trading.
In such forms as credit default swaps and collateralized debt obligations, derivatives were a major factor in spreading toxic mortgage-backed securities and other money-losing assets deep into the worldwide financial system.
But as much as derivatives are derided, lawmakers tread a fine line in carving out protections for their legitimate use by nonfinancial companies and even banks.
Dodd is asking for a two-year delay in implementing the ban proposed by Sen. Blanche Lincoln (D-Ark.) so that federal regulators can assess the effect on banks.
Key regulators and officials, including Treasury Secretary Timothy F. Geithner, question the wisdom of such a ban. The effect of the delay would be to allow regulators to kill the provision later.
As the name implies, derivatives derive their value from other assets — foreign exchange rates, soybean prices, even other securities. Although derivatives can be incredibly complex, the basic premise is simple: One party agrees to pay another party money if a certain prediction about the future is correct.
A farmer, for instance, can try to partially offset, or hedge against, a future drop in corn prices by buying a derivative that pays off if the price falls. An airline can buy jet fuel at a set price in the future to offset a possible increase in oil prices.
But investors also use derivatives to speculate. Investment banks and other financial companies can use derivatives to place bets on the price of oil, the credit rating on a corporate bond or the default of mortgages that back securities.
They have helped to turn derivatives into high-stakes gambling.
“The most important thing to understand about derivatives is that they are bets. That’s not a figure of speech — they are literally bets,” said Lynn Stout, a UCLA professor of corporate and securities law. “You can make a million-dollar bet on a $1,000 horse.”
Giant insurer American International Group Inc. used credit default swaps and collateralized debt obligations to place big bets on the rise of housing prices without buying any property or making any home loans.
The ability to make such bets is a big reason that the value of all derivatives can be about 10 times the world’s economic output.
Aided by deregulation a decade ago, the use of derivatives soared during the housing boom, with their overall value jumping to nearly $600 trillion at the end of 2007 from about $95 trillion in 2000. The world’s economic output was pegged at $55 trillion in 2007.
So a pandemic was poised to break out three years ago when the real estate market began collapsing in Southern California and other over-inflated regions of the country. Like trillions of infected mosquitoes, derivatives carried that financial illness far and wide.
Making matters worse, the largely unregulated world of derivatives left government officials with little sense that so many financial institutions would be exposed to the disease.
The government’s recent civil suit against Goldman Sachs Group Inc. highlights the complexity of derivatives and their potential abuse by financial firms.
The suit accused the Wall Street firm of failing to tell investors that a derivative it was selling had been created with significant input from a client who was betting that the securities would fail. Goldman denied it did anything illegal.
Federal prosecutors also reportedly are investigating whether another large derivatives dealer, Morgan Stanley, misled investors on some of its mortgage-based derivatives.
President Obama said the proposed regulations strike the right balance to inoculate the economy from another derivative-fueled crisis. Although the administration has indicated it might be open to changes in the legislation, Obama has vowed to veto any bill that does not strongly crack down on derivatives.
“We believe that there is a legitimate role for these financial products in our economy,” Obama told a gathering of corporate executives recently. “But the position of my administration on derivatives from the beginning has been simple: We can’t have a $600-trillion market operating in the dark.”
The financial regulatory reform legislation would dramatically change how derivatives are created and sold, adding oversight and transparency to prevent a repeat of the financial crisis.
• Most derivatives would have to be traded through central clearinghouses, which will require collateral to cover deals that go bad.
• Those derivatives would have to be traded on public exchanges, not privately, with prices and transactions reported to regulators and the public in real time.
• Large Wall Street banks, such as Goldman Sachs, JPMorgan Chase & Co. and Bank of America Corp., would be forced to spin off their lucrative derivatives businesses into separate companies.
One major point of contention centers on an exemption that farmers, airline companies and other non-financial companies would get from the proposed restrictions. A coalition of such companies and the U.S. Chamber of Commerce are pushing for broader exemptions so the firms don’t get caught by new regulations meant to rein in Wall Street.
“Because the end users represent a relatively small portion of the market, between 10% and 15%, they really can’t pose a threat to the stability of the financial system,” said Ryan McKee, senior director of the chamber’s Center for Capital Markets Competitiveness.
The financial overhaul that passed the House has a broader exemption for such companies. But the Obama administration and key Senate Democrats are worried that the House version could turn into a loophole that allows financial firms to evade tough oversight.
There’s widespread belief that speculators using derivatives helped drive the cost of oil to record highs before the financial crisis.
“When oil was ramping up to $150 [a barrel], our guys were there saying, ‘There’s a big problem, folks,’ ” said Jay McKeeman, vice president of government relations for the California Independent Oil Marketers Assn.
The group, which represents fuel wholesalers and distributors, is among about 50 state and national business groups supporting the Senate’s derivatives provisions and a narrow exemption to avoid creating loopholes that could be used by speculators.
But the U.S. chamber is leading a larger coalition of businesses concerned that the exemption is too narrow. A study done for the Business Roundtable, an association of chief executives at 169 major companies, estimated that the new regulations could force its nonfinancial members to put a total of $33.1 billion in reserve for collateral on derivatives that go through clearinghouses.
“I’m just worried that the broad brush of regulatory reform designed to fix our financial system will have unintended consequences,” said W. James McNerney, chief executive of Boeing Co., who wants a broader exemption.
Times staff writer Don Lee contributed to this report
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