Don’t Repeal Swaps Push-Out Requirements (Section 716 of Dodd-Frank)

By Simon Johnson

Section 716 of the Dodd-Frank financial reform act requires that some derivative transactions be “pushed-out” from those part of banks that have deposit insurance (run by the Federal Deposit Insurance Corporation) and other forms of backstop (provided by the Federal Reserve). This is a sensible provision that, if properly implemented, would help keep our financial system safer, protect taxpayers and reduce the likely need for bailouts.

Now, at the behest of the biggest Too Big To Fail banks and as part of the House’s spending bill (to be voted on tomorrow or in coming days), this “push out” requirement is on the verge of being repealed. Democrats and Republicans should refuse to vote for the spending bill as long as it contains this requirement.

This is not a left vs. right issue. It is a fundamental systemic risk issue, on which people across the political spectrum who want to lower those risks can agree – Section 716 should not be repealed. In fact, some of the sharpest voices on this issue come from the right.

In a statement on Tuesday, Thomas Hoenig, appointed by the Republicans to be Vice Chair of the FDIC, said:

“In 2008 we learned the economic consequences of conducting derivatives trading in taxpayer-insured banks. Section 716 of Dodd-Frank is an important step in pushing the trading activity out to where it should be conducted: in the open market, outside of taxpayer-backed commercial banks. It is illogical to repeal the 716 push out requirement.”

And on Tuesday evening, Senator David Vitter (R., Louisiana) put the issue in its proper broader context,

“Ending too big to fail is far from over. Before Congress starts handing out Christmas presents to the megabanks and Wall Street – we need to be smart about this. Removing these risky derivatives that aren’t even necessary for normal banking purposes is important, and Members of Congress need to rethink repealing this critical provision.”

The effort to repeal Section 716 comes primarily from the largest banks (and some say from Citigroup), who claim that these restrictions are somehow onerous or unreasonable. These arguments have no merit.

Under Section 716, interest rate swaps, foreign exchange derivatives, and cleared credit derivatives can remain on the balance sheet of the insured bank. This is almost all derivatives. And hedging of risks by banks using derivatives is most definitely allowed.

The push out applies most notably to uncleared credit default swaps (CDS), equity derivatives, and commodity derivatives. (See Tom Hoenig’s statement for a succinct and precise statement of the issues.)

The point of the push out is to get these potentially high risk swaps away from the insured part of the bank – and away from the explicit backstop provided by deposit insurance (and ultimately by the taxpayer).

The big banks (such as JP Morgan Chase and Citi) are actually a complex collection of separate companies – only one of which is typically an insured bank. That insured bank is regarded as a better credit (i.e., lower risk) by people in the market precisely because of the federal government-run deposit insurance. Like all better credits, those banks get to borrow at lower costs.

If these swaps are pushed out from the insured part of the bank, these speculative derivative positions will be priced by the market based on their actual risk – not mispriced due to the backing of taxpayers. Thus the derivative activities of these four banks, conducted by their uninsured subsidiaries, will become more expensive to fund.

Really this is just taking the state out of subsidizing some of these particularly high risk derivatives. That would be no more than reintroducing the market and market pricing of credit risk.

The four largest banks (according to the Office of the Comptroller of the Currency, OCC) conduct more than 93% of all derivatives activities in the US. (That is using “total banking industry notional amounts”; if you prefer net current credit exposure, NCCE, the same banks are 82% of the industry.) The repeal of section 716 is for them.

Remember when JP Morgan Chase lost more than $7 billion in its so-called “London Whale” trade? That was a high risk, highly leveraged proprietary bet involving complex Credit Default Swap indices. And JP Morgan Chase’s bet, which reportedly had a notional value of more than $1 trillion, was funded in part with insured deposits. (Publicly available information indicates that JP Morgan Chase – just like Citigroup – has the vast majority of its derivatives activities run out of the insured bank.)

So the vote this week is simple. Democrats and Republicans should vote to, at least partially, bring back the market forces – by rejecting the repeal of Section 716.  End state subsidies for these megabanks’ derivatives activities.

This is not what Citigroup, JP Morgan, Bank of America, or Goldman Sachs wants, of course. They want government insurance and their derivatives dealing to be subsidized by taxpayers, on the most favorable terms possible: it lowers their costs and increases their profits. As a result, Too Big To Fail banks’ executives and traders get the upside when things go well; and when things go badly, the downside is someone else’s problem.

Or, as Dennis Kelleher of Better Markets puts it,

“If Wall Street gets the upside in big bonuses from its high-risk derivatives deals, then it should also have to pay the downside for any losses.”

Remember that Citi’s lobbyists and their colleagues worked long and hard during the 1990s to relax all meaningful limits on their ability to take big risks. And the firm subsequently hired top Clinton-era officials to guide their economic and political strategy in the 2000s. This ended very badly – with the near-failure of Citigroup, multiple taxpayer bailouts, and a deep recession from which, six years later, we have not yet fully emerged. Citigroup was at the epicenter of what went wrong on Wall Street in 2007-08 and received more bailouts than any other single institution, almost $500 billion.

In the 1990s there was a Citigroup-inspired consensus in favor of deregulation. That legislative push proved to be a mistake, but at least it was done in the open. Now similar forms of deregulation – encouraging excessive risk-taking – are being pursued through back-room deals, with no hearings, and no debate.

To start again down the same path – and at the instigation of the same set of banks – is pure folly.

And to do it through this underhand process shows you that the big banks have no intellectual arguments left on their side. All they have to offer now is the prospect of large campaign contributions.

12 responses to “Don’t Repeal Swaps Push-Out Requirements (Section 716 of Dodd-Frank)

  1. I think just being a congress person today involves an extremely large amount of highly systemic risk. Lets get lobbying out of politics altogether, and reform the tax code, when a congress person can’t even do their own taxes, the tax system is too complicated, or the quality of the congress person is too low. This article is common sense folks, if our representatives can’t see this wrong, then they are and have been, the peoples problem(s).

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  3. This comment presupposes somebody knows what is really “risky”… and to believe in such nonsense is a truly immense systemic risk.

    Just look at what happened. Bank regulators because they thought anything with an AAA-rating (such as the AAA securities collateralized with mortgages to the subprime sector); or real estate lending (like in Spain); or lending to “infallible sovereigns” were extremely safe allowed banks to hold such assets against much much less capital (equity) when compared to other assets … and so precisely in the “absolute safe assets” was where banks created dangerously large exposures and a real gigantic crisis ensued.

    Frankly I have not seen one valid argument that evidences that “uncleared credit default swaps (CDS), equity derivatives, and commodity derivatives” should, after bankers have cleared for the perceived risks, to be more risky than those “interest rate swaps, foreign exchange derivatives, and cleared credit derivatives” which are allowed to remain on bank balances.

    This crisis was caused by distortions… let us not make it worse by just introducing more sophistication in the distortions.

  4. “…..They want government insurance and their derivatives dealing to be subsidized by taxpayers, on the most favorable terms possible: it lowers their costs and increases their profits…..”

    This “subsidizing by taxpayers” HAS ALREADY BEEN PROVEN TO BE ILLEGAL. IT WAS A HEIST. A orgy of Nihilism. This is nothing more than writing a law that makes the enforcement of past laws illegal.

    WHO (names, please, of the weasels and nimrods) sneaks in these things into these “laws” that, if put through a GCLP, would end up being a baseline analysis of sewer effluvium!

    TOXIC assets…..

    I really think we are all too civilized here – we are up against rabid raccoons…..NO HOPE for a cure.

    Meanwhile, there has to be a joke in here somewhere –

    “….an atheist and a Mormon walk into the CIA….”

  5. Per nothing should be rated AAA unless it can live a thousand years, where it all went bad is anyone guess, (passing torches and such) because there are a thousand ways to be wrong, and only one best way to be right. Just the fact that anyone can charge more than 10% interest is the first crime, break that, then make up your own rules only adds to criminal behavior(s). Do the math, the $18 trillion debt vs the yearly GDP suggests that everyone would have to work for free for a year and support themselves in order for the debt to be paid off. This simply can’t be done and will prove to a risk you are not prepared for, I guaranty it.

  6. Anonymouse writes: “Per nothing should be rated AAA unless it can live a thousand years, where it all went bad is anyone guess”

    Forget it! It was clear what was going to happen when regulators decided that the capital (equity) requirements for banks were to be based on credit ratings.

    In January 2003, more than one year before Basel II was approved, in a letter in the Financial Times I wrote “Everyone knows that, sooner or later, the ratings issued by the credit agencies are just a new breed of systemic error to be propagated at modern speeds”

    The problem was though that although everyone knew, or should have known… few really cared.

  7. The spending bill has unfortunately passed the house. John Boehner needs to go for pushing through such a malicious piece of legislation.

  8. Sad, but predictable. Mr. Johnson’s deep and well resourced admonition of this “underhanded”, and blatant giveaway to the four major TBTF oligarchs, was ignored by our socalled politicians, who despicably – yet again, – acted against and contrary to the peoples best interests, and instead advanced and protected the best interests of the predatorclass and predatorclass oligarchs they obediently worship and serve.

    Unspoken in this tragic episode by the paid spaniels and parrots of the socalled MSM is the why? Why would shaitans in the gop underhandedly sneak this pernicious giveaway to the predatorclass, and predatorclass oligarchs and basically extort this perfidy into the strange and aptly named “cromnibus” appropriations bill. Words like extortion, collusion, profiteering are never mentioned. All parties are painted and pretty lights and nice language, insipidly ignoring and excusing the horror of this action, and the nefarious purposes behind it’s implementation. .

    Forgive me for using this tragedy for commentary on a much larger, though perhaps off topic admonition. Amerika is the great satan. The people have no voice in the conduct of socalled government.
    Said government is owned, controlled, and obedient to the interests and individuals of the predatorclass, and predatorclass oligarchs alone, exclusively, and singularly.
    The pigs – I mean our socalled law enforcement are militarized, anti minority, anti poor, anti dissent thugs and mass murderers, unaccountable, immune, and above and beyond the socalled rule of law.
    Amerika is 17 Trillon dollars in debt! Divide that number by a population of 350+ mlllion, and get back to me on the future of Amerika’s children. There has never been a wider divide between thehaves, and havenots, in any nation anywhere on earth, in the history of the world.
    1% of Amerika’s fascists, the predatorclass, and predatorclass oligarchs own and control, 80% of America’s wealth and resourcess.
    Fascists and shaitans have commandeered every structure of our once more perfect union and shapeshifted what was America, and American principles, and that thing we call the Constitution into a shredded, tattered, piece of worthless trash.
    These fascists glorify and defend torture. (Any creature that would argue or defend the perverted, and freakish barbarism, and psychopathic degeneracy and sexual depravity of Amerika’s torture policies is below human) What kind of human being would even think of this level of depravity and sexually perverted behavior for any reason?
    Then we are all subjected to the embarrassing travesty of perverted freaks, massmurdering psychopaths, pathological warmongers and liars, warcriminals, and sexually depraved, shaitans, and freaks, like that slithering reptile, and satanic beast dick cheney, and equally criminal fascists and nazi’s like hayden, brennan, bushtheidiot, and all the slithering slimy creeps, and apologists for, and defenders of torture, including the arch betrayor obama. There is no painting lipstick on the disgusting pig that is torture. Feeble attempts to prettify this evil by terming it EIT, and conjuring and bruting a putrid litany of naked lies to justify this nefarious, sexually perverted, and inhuman, depraved behavior and policy sanctioned by the highest overlords in our socalled government is futile and repulsive It’s sickening.
    Amerika spends more money on defense than the next ten nations on earth combined on socalled defense, actually warmaking, and warprofiteering More a trillion dollars in defense, blackworld, and contractor taxpayers dollars are absconded yearly – and the worlds hypersuperior military must resort to depravities sexual perversions that would embarrass inquisitors, and inspire Vlad the Impaler??? This in the shady light of neverending wars that were deceptively conjured, by the office of special plans, and other warprofiteering projectforthenewamerikancentury covens, pimping and bruting, Amerikan supremacy, newworldorder, and totalspectrumdomination.

    Amerika is the great satan. We deserve, and will get, what ever fiery pit and hell we sheepishly and silently allow our perverted, fascists, and psychopathic massmurdering warmongering, warprofiteering socalled leaders hurl us into.

    Back on topic. The total exposure of the derivatives market, by my understanding is 3/4 of a quadrillion dollars? Asked numerous times for our erudite economists and financial experts to reject or validate this number, but that is my understanding. Though the numbers are nebulous due to the lack of disclosure, and any regulation, – the total exposure of the derivatives markets is around $750 Trillion. 3/4 of a quadrillion. Quadrillion is number not even imagined nor comprehended outside of the most brilliant scientists working on astronomic or particle physics.

    How is this ponzi scheme, – a ponzi scheme the shaitans in the gop, slithered, and extorted into the budget, and the rank cowards in the democratic party – just sanctioned, and advanced, – ever reconciled? The entire global GDP is less the $80 Trillion. Is no one on this wild and weird at heart earth capable of simple math? How can these gargantuan, and absurd numbers ever be reconciled? How can there be any justification for torture? How can we tolerate systemic criminality and the greatest, largest theft in the history of the world, by the den of vipers and thieves on wallstreet? How can and do we allow psychopaths, warmongers, warprofiteers, satanic beasts (dick cheney) massmurders, warcriminals, tyrants, perverts, freaks, shaitans, pathological liars, and a den of vipers and thieves to walk free, immunized, unaccountable, above and beyond the socalled ruleoflaw, untouchable – and yet exalted, criminally commandeering imponderable wealth, and untoward illicit power? How we tolerate this evil, this perversion, this thievery, this systemic lying, the slaughter wanton thievery, and this rank putrid abuse???

    We can’t! Some of us won’t! In a world where are no laws – there are no laws for anyone predatorclass biiiiiaaaatches!!!

  9. 219 to 206 – so how come it has to be 60 to 40 in the Senate?

    The protesting against this started WAY too late in the process – seriously, who snuck this in…?

    Let’s face it, they all have too much dirt on each other in D.C. to operate in any other way than blackmailing and blackballing each other….

    “….all other means of putting an end to it must have been shown to be impractical or ineffective….”

    Repeat a “meme” long enough and it will sink in…? Nope, not true – so here it is again:

    The just war doctrine of the Catholic Church – sometimes mistaken as a “just war theory”[15][16] – found in the 1992 Catechism of the Catholic Church, in paragraph 2309, lists four strict conditions for “legitimate defense by military force”:[17]

    1. the damage inflicted by the aggressor on the nation or community of nations must be lasting, grave, and certain;
    2. all other means of putting an end to it must have been shown to be impractical or ineffective;
    3. there must be serious prospects of success;
    4. the use of arms must not produce evils and disorders graver than the evil to be eliminated (the power of modern means of destruction weighs very heavily in evaluating this condition).

  10. While we were all looking at the terror report….and chanting “I can’t breath”….

  11. From the desk of Thom Hartmann:

    “Last night, with only hours to go before the government shut down, the House of Representatives passed the so-called “Cromnibus” bill to keep government running. As usual, Republicans used the looming deadline to force through massive cuts and more deregulation. And, once again, far too many Democrats went along with the Republican hostage-taking.”

    “The $1.1 trillion dollar spending bill passed in a 219-to-206 vote, with 57 Democrats voting to approve the budget – despite its disastrous provisions. Thanks to the new legislation, the IRS and EPA budgets have been slashed and the Pell Grant program was hit with $300 million in cuts. Pension guarantees for retired workers have been gutted, and programs like HUD and Section 8 were denied nearly a billion dollars of their requested funding.”

    “In stark contrast, those cuts didn’t prevent billions in new spending for military operations, or stop Wall Street from getting taxpayer-backed protections for the same high-risk derivatives that crashed our economy. And, as if that wasn’t enough, a rider in the bill made it possible for billionaires to give ten-times more money to political parties, and for the rich to have even more power in our political system.”

    “Despite all these facts – and the many more that are sure to be uncovered – 57 Democrats refused to stand with their Progressive colleagues and stand up to Republicans. This is what happens when lawmakers answer only to those at the top, and that’s not limited to those on the Right. This legislation is a slap in the poor and the working class, and a big holiday gift to Wall Street and military contractors.”

    “Every time Democrats give in to this type of legislation, they set themselves up for the next round of Republican demands. It’s time to let them know that we’ve had enough. We’ve got two years to make it clear that we want lawmakers who will stand up to the hostage taking at all costs, so let’s get busy making our voices heard.”

    * * * * * * * * * * * * * * * * * *

    I told you so back in 2009 – never, ever should the federal government bailed out the banks.

    Lives were already ruined, the economy almost tanked (which, instead, we should have rightly plunged into a huge Depression – at least, that would have stopped most of all the academic political ivory tower b.s. about how the elite are better to be running the country instead). And if you think this is bad, wait ‘til the TransPacific Partnership goes through.
    Senator Warren needs to reframe some of her talking points, starting with this: Mr. President, this bill isn’t about Compromising. It’s not about the bipartisan clap trap we keep hearing from both Parties and from you (the president himself). It’s not about you, Mr. President. It’s not about being anti-free markets, anti-innovation, anti-Wall Street, blah blah blah. Mr. President, this bill is about what our Founding Fathers warned against… Thomas Jefferson, Andrew Jackson…. even the former president Ronald Reagan knew about unchecked powers, income inequality……..

    Senator Elizabeth Warren, where is Hillary Clinton on the issue of TBTF, Wall Street, Citizens United, Keystone Pipeline, Transpacific Partnership and other issues since the time you have endorsed her possible candidacy for president?

    Yours truly,

  12. Thanks so much for this cogent description about last week’s events. Warren’s comments at the “Managing the Economy” conference were so interesting to watch in the context of what happened later in the week! I also appreciate your commentary in this post and the advocacy of your previous two posts. I voted for Senator Warren, and I think she’s represented my views well.

    It will take knowledgeable, devoted, and optimistic people (like Warren, Vitter, and yourself) to keep the country informed about these specific, common-sense civic issues when we’re so inundated by mass media misinformation that tries to convince us that the REAL problem (taking my cue from other comments here) is somehow related to an overarching ideology or a much broader set of issues.

    If some of the events predicted by the title and text of Ralph Nader’s book from earlier this year—”Unstoppable: The Emerging Left-Right Alliance to Dismantle the Corporate State”—happen sooner rather than later then the event described by the title of your blog post will also happen soon.