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Why Financial Reform Hinges on Defusing Derivatives

By Alain Sherter

Updated on: June 9, 2010 / 5:15 PM EDT / MoneyWatch

For lawmakers who will start thrashing out financial reform later this week, the most important issue is what to do about derivatives. Global economic stability hinges on managing the inherent danger in credit default swaps, synthetic credit debt obligations and similar securities. Controlling derivatives is "an absolutely essential part of protecting our financial system and making sure our financial system does what it's supposed to do," said Nobel Prize-winning economist Joseph Stiglitz in a conference call today to discuss the reform legislation.

If that sounds like an overstatement, it's not. The derivatives market has a total notional value of $600 trillion. That's 10 times world GDP. More to the point, misuse of these instruments is wreaking economic havoc. They were a principal cause of the financial crisis, and more recently were implicated in the sovereign debt crisis enveloping Europe and roiling markets around the world.

How to defuse these "financial weapons of mass destruction," as Warren Buffett famously called them? Start with passing a proposal by Arkansas Democrat Blanche Lincoln, known as Sec. 716 in the Senate bill, that would force U.S. banks to separate their swaps desks from their commercial businesses, said Stiglitz, of Columbia University, and former top Commodity Futures Trading Commission official Michael Greenberger.

The measure aims squarely at Wall Street. Five institutions -- Bank of America (BAC), Citibank (C), Goldman Sachs (GS), JPMorgan Chase (JPM) and Morgan Stanley (MS) -- control some 90 percent of the derivatives market. These banks "have to be told, 'The risk is yours, not the American taxpayer's,' " Greenberger said. "There's no doubt that Sec. 716 will increase market discipline and will bring this $600 trillion market to a size that's realistic. And the risks that are taken with these transactions will be cut down when [bank] shareholders or directors know that they, and not the American taxpayer, will be the lender of last resort."

Big banks and other opponents of the Lincoln plan, including the White House, Federal Reserve Chairman Ben Bernanke and FDIC chief Sheila Bair, attack it on several grounds. The most serious of these is that it would prevent banks from serving their customers. Detractors also say the measure would push derivatives trading overseas or into unregulated parts of the market.

Neither claim holds water, Stiglitz and Greenberger said. Nothing in the legislation would prevent banks from setting up a separately capitalized affiliate for selling derivatives. What it would do is bar institutions from using federal deposit insurance and debt guarantees -- a mammoth "get out of jail" card for speculators -- to subsidize their swaps business. Meanwhile, a bank's derivatives unit would be fully regulated after it is spun out, they explained, dismissing as "mythology" the idea that Lincoln's plan would cause chaos in the financial sector.

"The bank can clearly serve its customers if it chooses to do so," said Greenberger, now a law professor at the University of Maryland. "It just can't do it in a way that makes the taxpayer the lender of last resort for what is a highly systemically risky market."

Stiglitz emphasized that regulating derivatives isn't merely a matter of making the financial system safer. It's also to help the economy in its central role of allocating capital. Derivatives are effectively underwritten by the U.S. government, distorting the capital markets, he said, noting that financial firms and investors gamble with derivatives secure in the knowledge that taxpayers will cover outsized losses.

I've been openly skeptical that Lincoln's proposal has much of a chance of making it into law. President Obama hasn't gotten behind the measure, while numerous pols on both sides of the aisle oppose it outright. Stiglitz is more optimistic, pointing to Lincoln's win yesterday in the Arkansas primary as a sign that her derivatives measure is gaining traction.

"The fact that Sen. Lincoln has come out with a strong proposal has really been part of the basis of her support and how well she did," he said. "And that, in turn, I hope is sending a strong message that the American people do want strong regulatory reform, not the kind of regulatory watering down that the banks want."

Perhaps. Certainly having Lincoln on the Senate committee reconciling the reform bills will help. As always, though, it's less a question of what the public wants than whether Congress is willing to listen, especially as financial industry lobbyists go into overdrive. I'm still not sure it will. But I'd love to be proven wrong.

Missile image from Herzobase.org; photo of Stiglitz from Wikimedia Commons, CC 2.5 Related: