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Financial Reform Gets Bipartisan Boost in Derivatives Rule Vote

April 21, 2010 at 12:00 AM EST
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Lawmakers moved closer to passing sweeping reform of the financial system as a Senate panel approved new regulations for the complex derivatives market with the backing of GOP Sen. Charles Grassley of Iowa. Jeffrey Brown talks to experts about derivatives rules and the overall reform effort.
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JEFFREY BROWN: There was movement on the road toward financial regulatory reform today in Washington and even some talk of compromise. It came on a day when a key part of the reform package, regulating derivatives, advanced in a Senate committee.

SEN. KAY BAILEY HUTCHISON, R-Texas: I think that we are in a good position. I’m very optimistic. And this is the way that I think legislation should be approached.

SEN. JACK REED, D-R.I.: We have to do it now. And the time for discussion, the time for consideration privately has passed. Now we have to act.

JEFFREY BROWN: That was the tone around the Capitol today, as bipartisan efforts appeared to gather momentum on financial reform.

Just last week, all 41 Senate Republicans had lined up against the bill. They focused on a provision for a $50 billion fund collected from the banks. It would be used to help dismantle large banks facing failure.

Republicans charged, it would lead to more federal bailouts. Democrats disputed that, but White House officials signaled a willingness to work something out. By yesterday, Minority Leader Mitch McConnell of Kentucky was talking up chances for a deal.

SEN. MITCH MCCONNELL, R-Ky., minority leader: We have an opportunity here to do something that wasn’t done in the House of Representatives, where they produced a bill that had no Republican support whatsoever. Serious discussions are under way, and I think that’s a good sign.

JEFFREY BROWN: White House Chief of Staff Rahm Emanuel also sounded hopeful on Monday in an interview with PBS’ Charlie Rose.

RAHM EMANUEL, White House chief of staff: I think it will be bipartisan, because I think people realize, Charlie, that, while it’s been 14 months, 12 months, and there are still damages from that crisis, that you have a financial system over the last 20 years that raced ahead of where the regulatory system was.

JEFFREY BROWN: But the bipartisan road ahead remains uncertain. Today, the Senate Agriculture Committee moved to update part of the regulatory system, imposing curbs on derivatives, but largely on party lines.

Derivatives are complex financial instruments that allow traders to bet on the direction of prices of stocks and other assets and much else. Some derivatives are well-known, like corn futures, and lock in prices for goods that fluctuate in value.

More exotic derivatives, including credit default swaps, have been blamed for fueling the global financial crisis. The Senate committee approved strict limits on big banks trading in derivatives. And it required nearly all derivatives contracts to be traded openly on exchanges.

The committee’s chair, Arkansas Democrat Blanche Lincoln, said it would be a bold change.

SEN. BLANCHE LINCOLN, D-Ark.: We must bring transparency and accountability to these markets. This is not a partisan issue. I believe every Republican and Democrat in this body is committed to doing what is right to put our economy back on track.

JEFFREY BROWN: The vote was 13-8, with one Republican, Senator Chuck Grassley, joining all 12 Democrats. The derivatives measure is expected to be folded in to the broader reform bill. The full Senate could schedule a final vote on that measure next week.

And we take a closer look at all this now. Lynn Stout is a corporate and securities law professor at UCLA. She specializes in securities regulation. David Skeel is a professor of corporate law at the University of Pennsylvania Law School.

Lynn Stout, I am going to safely assume, I think, that most of us don’t really get derivatives, what they are. So start there. What is your — what is your simple definition? And what is the problem they have come to raise?

LYNN STOUT, corporate and securities law professor, UCLA: Well, some particular kinds of derivatives can be very complicated for an outsider to understand.

But I think they make more sense when you boil them down to the fact that what derivatives really are, are just bets. They’re bets between parties over what’s going to happen in the future. Interest rate swaps, for example, are bets on what is going to happen to interest rates. And, if interest rates go up, the party that wins the bet gets money. And, if they go down, the party that loses the bet makes money.

Credit default swaps are bets on whether particular bonds, maybe mortgage-backed bonds, are going to go up or down in value, and because they become more or less risky. And, again, if they become more risky, the party that wins the bet gets money, the party that loses the bet has to pay the money.

So, they’re really just bets on the future. And, sometimes, betting can be very economically valuable when it is used as a form of hedging against risk. And, sometimes, betting is just speculation. And, as we have learned, pure speculation can actually add risk and lead to institutional failures.

JEFFREY BROWN: So, David Skeel, what would you add here? They went from being relatively simple hedges or insurance instruments to something more complex, something less regulated, something far more risky.

DAVID SKEEL, professor of corporate law, University of Pennsylvania Law School: They absolutely did.

And I think one of the major reasons for that was simply that derivatives can be used in many cases to evade regulation. And many of the most complex derivatives are used to get around one form of regulation or another.

JEFFREY BROWN: So — staying with you, so, when you look at this — this measure before the Senate now, one of the thing — part of this involves limiting what commercial banks can do with derivatives.

Explain what they’re trying to do there in limiting — limiting that activity. And what are the pros and cons?

DAVID SKEEL: Well, that particular piece of the proposed legislation, which is part of Senator Lincoln’s package, is designed to prevent banks from dealing in derivatives, from participating in the derivatives market, at least in the banking part of the business.

And the idea is, to use Lynn’s expression, that a derivative can be a bet. Banks are funded by taxpayers. We guarantee the deposits in banks, and there is a real concern that banks not be enabled by our taxpayer guarantees to place bets.

So, that would be the upside or the argument for the regulation. The downside, in my view, is, it is not clear how much it is going to do. Banks will — if they can’t deal in derivatives in the banking part of the business, they will move the derivatives to another part of the business.

So, the downside is, the main effect of this part of the package may be simply to add costs to the banks in its derivatives operations.

JEFFREY BROWN: Lynn Stout, how do you see this — this particular part of the package?

LYNN STOUT: I think that there’s a lot of strong arguments to be made in favor of this part of the package.

Essentially, what the bill says, now that it has come out of the Agriculture Committee, is that banks have to decide, are they going to be banks or are they going to be bookies? They don’t get to be both.

And I think David Skeel has described very well why we don’t want our banking institutions necessarily gambling on the side. But I think perhaps even the more important part of the legislation — and — and this is really an extremely significant development that many people thought might never happen — is that another part of the proposed legislation would require derivatives that were being used for speculation, and not for true hedging, to be traded only on exchanges or clearinghouses, where they were, in effect, subject to adult supervision.

That’s a key provision.

JEFFREY BROWN: Yes, now, explain — explain that a little bit more for us, because that goes to what we saw in our clip Senator Lincoln referring to as the transparency and accountability part of that.

But what is — what is meant by a clearinghouse, for example?

LYNN STOUT: Well, clearinghouse and exchanges, they are both simply places where derivative dealers have to go, and they have to make their derivative contracts public.

And the contracts are inspected by and guaranteed by whoever owns and manages the clearinghouse or the exchange. So, what it essentially does is prevent these private backroom deals, where it is not absolutely clear that both parties to the contract would actually be able to pay off their bets, depending on what happens in the future.

So, we have had clearinghouses and exchanges for certain kinds of derivatives for well over 100 years. They have proven themselves very successful at preventing the kinds of disastrous collapses like we have seen with AIG, Bear Stearns, and Lehman Brothers.

And, so, by moving speculative derivative trading back on to the clearinghouses and the exchanges, this bill may do more than almost anything to prevent a repeat of the disaster — disastrous institutional failures we have seen in the last few years.

JEFFREY BROWN: And, yet, David Skeel, this is an area where some of the investment houses and banks have fought against as well.

But what — what would you add to this explanation of the meaning of the exchanges and clearinghouses and how it would change things?

DAVID SKEEL: I would just reinforce some things that Lynn said.

In particular, I think it is useful to distinguish between the exchange component and the clearinghouse component. The exchange idea is just the idea that derivatives should be bought and sold like shares of stocks are, like General Electric or Microsoft stock is.

And the idea is, if you trade them on exchanges, there will be more transparency; nothing will be taking place in the dark. The clearinghouse part of the reform is basically designed the put a middleman between the two parties in a derivatives contract.

And the role of the clearinghouse is to guarantee those contracts so that, if either party fails to perform, the clearinghouse will step in. And this will prevent the kinds of huge disasters that we saw in 2008, in particular. So, there are two different kinds of reforms, although they’re closely connected.

The one Wall Street is really worried about is the requirement that derivatives be traded on exchanges. And the reason they’re worried about it is, Wall Street banks make a huge amount of money from making tailor-made derivatives that wouldn’t and do not trade on exchanges.

So, this — this threatens to take away a big profit center from Wall Street banks.

JEFFREY BROWN: So — so, Lynn Stout, now put this in this larger perspective of the larger overhaul package.

We saw that there might be some movement here. How does the derivative piece of it fit into the larger package, and do you see the pieces — all the pieces starting to come together?

LYNN STOUT: I think that the derivatives piece is, if not the single most important piece, certainly one of the most important.

And I think it is really notable how the bill that is coming out of the Senate has got real teeth on it. It is a real reform and addresses the root of the problem. Some earlier versions of this bill that we had seen come out of banking in the Senate looked like reforms, but they were riddled with huge exemptions that suggested they wouldn’t be very effective.

So, if this bill can get through, I think that will be an enormous step in the right direction. There are other strategies that can be adopted to try and prevent a repeat of the disastrous last two years, and those are also being pursued.

But I would say this is probably the single most important piece, even if it is perhaps the piece that is the least well-understood by most people.

JEFFREY BROWN: That is probably for sure.

JEFFREY BROWN: David Skeel, a brief last word from you. Do you see roadblocks still ahead here? Where are we at?

DAVID SKEEL: I’m greatly encouraged in two respects, first, that we’re talking about derivatives. They are enormously complicated. People even in Washington don’t like to talk about them.

But, as Lynn said, they really are the heart of the matter in so many different ways. The second thing I’m encouraged by is, it looks like there may be a little bit of bipartisan movement. I have thought all along that the politics of financial regulation were really different than the politics of health care. And it is looking like that might prove to be true.

JEFFREY BROWN: All right, we will leave it there and watch.

David Skeel and Lynn Stout, thank you both very much.

DAVID SKEEL: Oh, thank you so much.

LYNN STOUT: Thank you for having us.