Feingold v. Fernholz: Vote For Wall Street Reform

Sen. Russ Feingold, D-Wis., is defending his decision to vote against the Wall Street reform bill on the grounds that it is simply too weak to prevent future crises, and Tim Fernholz is crying foul.

On policy substance, Feingold is undoubtedly correct. From Feingold:

At the start of this process I made clear that I had a simple test for financial reform — will it stop another financial meltdown? This bill fails that test.

Fernholz claims, to the contrary:

The bill will make bailouts very unlikely and bring derivatives out of the shadows.

I just can’t see how Fernholz can believe that line. Megabanks have spent the past two years “earning” their way back to health with the riskiest businesses—derivatives operations and proprietary trading. They’ve managed to make enormous profits from these trading operations even as the global economy has crumbled. At some point, the economy is going to catch up with the trading, and there is going to be a problem. But it will be seven to 12 years before the critical reforms reining in these activities will actually take effect (and for the most part, those reforms have been gutted). Blanche Lincoln’s derivatives language has a seven-year phase-in, and will not apply to the vast majority of derivatives currently being traded. The Volcker Rule ban on prop trading still allows banks to gamble with hedge funds, and this rule will take a dozen years to implement.

In short, we’ll be living through the next crisis before these rules take effect.

The bill does give policymakers a new resolution authority to shut down failing megabanks, but without a major reduction in both the scope of bank derivatives businesses and proprietary trading operations, this authority is an idle threat, and key players in the market have already expressed that view. By wrapping themselves in complex webs of trading risk—via hundreds of millions of dollars in trades every day—big banks make it nearly impossible for regulators to figure out what will happen when the bank goes down. That makes policymakers extremely reluctant to actually shut them down, with or without a resolution authority. In the 2008 meltdown, regulators had the power to shut down the ordinary, boring commercial banking operations of every bank in the country. They could have shut down nearly all of the Wachovia Corp. holding company, or the commercial banking units of financial behemoths Citigroup, Bank of America or Wells Fargo, but simply chose not to. We will see the same choices made the next time these megabanks get themselves into trouble.

By “bringing derivatives into the light,” I expect that Fernholz means that much of the market will now be subject to central clearing requirements. Right now, derivatives are traded in secret, with no market or regulatory scrutiny, and central clearing will put an intermediary between the trade to verify that each firm can make good on the trade. If one firm ultimately can’t make good on the trade, this intermediary makes good on it for them, preventing the cascade of defaults that policymakers were worried about when AIG went under in 2008.

It’s true that about 90 percent of the current derivatives market will now be subject to market scrutiny through central clearing—but Congress carved out a major loophole allowing banks to continue trading in secret with financial firms like hedge funds and private equity. We’re just going to see the riskiest aspects of the derivatives business move from bank-to-bank trading into bank-to-hedge-fund trading. What is now only 10 percent of the market will soon be much larger. Since a bank is still connected to the trade, we’re still subsidizing the shadow markets, and the payments system is still at risk.

The brutal truth about this bill is that it will not accomplish what President Barack Obama and the Democratic Congressional leadership are advertising. It will not avert future meltdowns, and it will not end taxpayer bailouts. What’s worse, Congressional leaders had a chance to actually get it there. If they had implemented a strong Volcker Rule or kept Blanche Lincoln’s derivatives language—both of which survived until the final day of negotiations—they really would have forced banks out of destructive businesses, and at least given the resolution authority some shred of credibility. Instead, they gutted both provisions to win over Republicans while leaving Feingold to twist in the wind. That was a dramatic failure of leadership.

But for all of that, I think Fernholz is still right about the politics of this bill. It’s worth a “yea” vote. Fernholz correctly notes that the new bureau tasked with protecting consumers from bank abuses is critically important. Still better is a very significant audit of the Federal Reserve, which can build more momentum for further reforms. And for all the shortcomings of the derivatives rules, we will at least put in place regulatory infrastructures that can be expanded by future legislation.

This bill will not, as Feingold claims, create “false security” for the public or the capital markets, so long as people like Feingold keep sounding the alarm about its shortcomings and continue to demand stronger medicine. We will have plenty of opportunities for major reforms in the coming months. With Republicans screaming about the deficit, a financial transactions tax is a great way to bring in tax revenue while simultaneously limiting risky Wall Street speculation. When Congress determines what to do with Fannie Mae and Freddie Mac, reformists can make that bill about the broader issue of too-big-to-fail, and push to break up the megabanks.

Despite all the ill-treatment he’s received on this legislation, Feingold should still vote in favor of the Wall Street overhaul. But he should also keep pressing his colleagues to adopt more serious financial legislation.

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