The following guest post was contributed by Jennifer S. Taub, a Lecturer and Coordinator of the Business Law Program within the Isenberg School of Management at the University of Massachusetts, Amherst (SSRN page here). Previously, she was an Associate General Counsel for Fidelity Investments in Boston and Assistant Vice President for the Fidelity Fixed Income Funds.
It’s about time. Yesterday, by a vote of 96 – 0, the U.S. Senate passed a ground-breaking amendment to the financial reform bill. Introduced by Senator Bernie Sanders of Vermont, this amendment would require an audit of all emergency actions taken by the Federal Reserve since December 1, 2007. In addition, the amendment mandates that by December 1, 2010, the Fed reveal those who received $2 trillion in zero or near zero interest Fed loans and what those institutions did with the money.
This was the second recent “yes we can” show of bipartisanship. Last week, by a 96 -1 vote, the Senate approved an amendment introduced by Senator Barbara Boxer of California. The Senator described its purpose was to “protect taxpayers” through the creation of an “orderly process to liquidate failing financial firms and ensure that Wall Street pays to clean up its own messes.” Whether the amendment can live up to that promise is a good question. The answer depends less upon government intervention once a firm nears collapse and far more upon government prevention of the excesses that lead both to widespread failure and government support.
Moreover the impact on the American taxpayer of failing banks goes well beyond government spending. And as articulated here by Simon Johnson, cross-border complexities prevent the efficacy of a seemingly elegant US-based resolution mechanism. As the S.A.F.E.R. economists opined, “It’s Prevention, Stupid.”
So, where am I headed with this line of thought? Here goes. These votes where 96 Senators, across notoriously rancorous party lines, support something, should send a signal. The way I interpret the signal is that these elected officials understand that voters want transparency and voters want to avoid bearing the costs of financiers’ excesses. Thus, it is quite logical that the Senate should also overwhelmingly support preventing the very riskiest behaviors that required the bailouts. The Senate should support refusing to provide a Federal Reserve or FDIC or other lifeline to firms engaging in the high-profit, high risk behavior that enriches their executives, threatens the firms, creates systemic risk and cause widespread disaster.
At the top of that list are swaps. Swaps have been at the heart of major financial crises since the bankruptcy of Orange County. The Long-Term Capital Management meltdown, the failure of AIG and the Greek debt crisis, share this common component. Thus, it was a welcome moment in the reform process when Chairman Dodd included in the Senate bill, Senator Blanche Lincoln’s proposal to require banks that receive Federal assistance to spin off swaps desks. A very useful interview of derivatives expert, Michael Greenberger on the Lincoln amendment can be found on Mike Konczal’s rortybomb blog.
While some important voices, like White House economic adviser, former Fed Chair, Paul Volcker and FDIC Chair Sheila Bair have raised objections to aspects of the plan, the title of the recent Huffington Post opinion piece by economists Jane D’Arista and Gerald Epstein makes the counter-argument concisely, “Banks Must Be Barred from Dealing Derivatives: It’s Not a Normal Part of the Business of Banking.” The authors explain:
“The controversial part of the amendment – section 716 – would ban Federal Reserve assistance through a credit facility or the discount window or loan or debt guarantees by the FDIC to any dealer in swap contracts. This would mean that banks that are insured by the FDIC – including the large banks that now dominate the market – would have to spin off their derivatives desks. Like the Volcker rule itself, the intent is to remove risky activities from the core banking functions that are essential to the economy and to ensure that those risky activities will not trigger the need for a bail out to prevent systemic collapse in the future as they did in the 2008 crisis.”
As a practical matter, this would affect the top 5 players who control about 90% of the swaps market, including Goldman, Morgan Stanley, Bank of America, Citigroup and JPMorgan.
Another swaps amendment that deserves overwhelming support was introduced by Senator Byron Dorgan of North Dakota. The Dorgan amendment would ban naked credit default swaps. A credit default swap is like a home insurance policy. With an insurance policy, the buyer pays the seller premiums. In exchange the seller agrees to cover the buyer’s losses if there is some bad event occurs and damages the home covered under the policy. Similarly with a CDS, the buyer pays the seller a premium based upon a percentage of the underlying asset, typically on a quarterly basis. In exchange, the seller will compensate the buyer if there is a bad “credit event” such as a default involving the reference bond. With a naked CDS, the buyer is purely betting on the default of the bond or other reference credit.
If this were insurance, this practice would be prohibited, as laws prevent the purchase of coverage if you don’t have an insurable interest. And, if it weren’t for federal preemption of state gambling laws in 2000 with the passage of the Commodities Futures Modernization Act, states could refuse to enforce these contracts, or treat them as unlawful gambling. It’s particularly ironic that conservative organizations are championing naked CDS when the existence of these instruments depends upon trampling on states’ rights. The language of the CFMA made this clear when it stated that “it shall supersede and preempt the application of any State or local law that prohibits or regulates gaming or the operation of bucket shops.”
Additionally, given the harm caused, including let’s remember the $180 billion taxpayer-funded bailout to AIG ($60 billion of which was paid through to bailout counterparties including $12.9 billion to Goldman Sachs), it is stunning that we have not had a moratorium on these instruments. From that safe vantage point, we should then do a study where we can intelligently assess whether the yet-to-be-quantified benefits outweigh the tremendous harm.
And, here’s a parting thought. The Senate may dazzle us with a 96–1 vote promising voters no more bailouts. That’s terrific. Thanks. But, hello? We still own about 80% of AIG. And AIG has not yet paid back its loans from the Fed. So, let’s get serious. Yes. I am glad that 96 senators agree that with regard to future messes, Wall Street should do its own clean up. But as for now, like the oil spilling into the Gulf, the mess continues and we have not been repaid. And, the mess, millions of jobs lost, double digit unemployment, massive cuts to state and local services, caused by the reckless practices on Wall Street remains. Thus, I welcome another bipartisan vote to spinoff the swap desks and ban the most dangerous swaps, since the financial sector has shown it cannot stop its toxic sludge from spilling into our economy and it has not completed the cleanup.