Will Wall Street Reform Be Gutted By A Technicality?

The tough derivatives overhaul proposed by Sen. Blanche Lincoln, D-Ark., has emerged as the key fight in Wall Street reform. That status is well-deserved. Despite Lincoln’s record as a stooge for corporate executives, she is pushing what is by far the most significant threat to the Wall Street bonus machine currently on the table. But what’s not as well-known is that Lincoln’s plan hinges on critical technicality elsewhere in the reform package that would thoroughly defang her plan if removed.

So far as the absurdly complex world of derivatives trading is concerned, the Lincoln bill is relatively straightforward: No more taxpayer subsidies for the crazy derivatives casino that brought down AIG and Enron. Taxpayers provide two key subsidies to the commercial banking system, namely cheap loans from the Federal Reserve’s discount window, and deposit insurance. Deposit insurance protects the public from losing its money when a bank fails, but that guarantee means banks don’t have to pay very much to win depositors’ money, making them a very cheap source of funding. Since just a handful of commercial banks deal nearly $300 trillion in derivatives, those subsidies are a very big deal.

By eliminating taxpayer subsidies, Lincoln would force banks to raise more capital against their derivatives deals, which provides a cushion against losses, and prevents banks from overextending themselves on risky activities.

To kill off the subsidies, Lincoln’s plan—known as “Section 716″ on Capitol Hill—would force banks to move their derivatives dealing operations into an independently capitalized affiliate company. That affiliate would have no access to taxpayer perks, and would not be able to use cheap Fed loans and deposits to book artificially inflated profits—and by extension, bonuses—on inherently risky derivatives deals.

But for this plan to work, the bank—a company with access to taxpayer perks—can’t be able to simply bail out its derivatives affiliate when it gets into trouble. Those bailouts would ultimately be financed by taxpayer subsidies, rendering the whole point of the Lincoln plan meaningless. There are already laws on the book that limit transactions between banks and their affiliates (for wonks: Sections 23A and 23B of the Federal Reserve Act), but the laws are weak. Fortunately, Section 608 of the Wall Street overhaul that cleared the Senate significantly strengthens those rules.

Current law only keeps banks from bailing out their affiliates with traditional loans. If they want to use a more complicated transaction, like, say, a derivative, to salvage the affiliate, they can. The Senate bill tightens this language, barring banks from bailing out their affiliates with both securities lending and derivatives operations.

This barrier isn’t ironclad, but it is meaningful. Banks can still devote up to 10 percent of their capital to transactions with an affiliate firm, but no more. That number may sound high, but remember—even if banks continuously push out 10 percent of their capital to their new derivatives affiliate, which they would never do for various technical reasons, that’s only one-tenth of what they’re currently allowed to use. It’d be better if this number were, say, zero, but banks really will have to put up a lot more capital to deal in the derivatives casino if the Senate language survives.

Even more important, Section 608 requires affiliates to post collateral for any transaction they engage in with their bank. That means no free lunch for the derivatives affiliate if it gets into trouble. While banks can still make (limited) arrangements to save the derivatives affiliate, the affiliate has to put up something of equal value in exchange. In other words, the bank can’t just bailout the derivatives house with taxpayer subsidies.

So watch Section 608 very closely as the conference committee on Wall Street reform reconvenes next week. With derivatives becoming the hot-button issue for the financial overhaul, very few lawmakers are interested in being caught publicly selling out to megabanks this late in the reform process, particularly with the November elections just a few months away. But they may very well gut a handful of less-well-publicized technical measures in an effort to gut the derivatives reform by proxy.

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