AIG Redux: Wall Street Presses Regulators To Repeal New Derivatives Rules

It's been pretty well-documented that the ultimate fate of Wall Street reform [1] will depend on a series of highly technical proceedings at federal regulatory agencies. If regulators adopt tough new rules, the financial overhaul could succeed well beyond the expectations of optimistic reformers. But there is a very real danger that banks will be able to roll regulators during these quiet and technical affairs, without any real public oversight. One of the most important areas to watch are the rules surrounding derivatives—the shadowy market that brought down AIG. The battle is already under way, and the bank lobby isn't pulling its punches.

Wall Street reform basically did two things unquestionably well. It created a new Consumer Financial Protection Bureau to curb bank abuses, and it reined in the derivatives market, which is currently a hotbed for fraud, abuse and systemic risk. There are dozens of smaller-bore accomplishments in the Dodd-Frank bill, but derivatives and the CFPB are the two major wins.

Take a look at this 7-page letter from The American Bankers Association [2]—the bank lobby—and this 10-page letter from the International Swaps and Derivatives Association [3] (ISDA)—another Wall Street lobby group. See if you can spot where they regulators to completely erase the legislative progress on derivatives.

You probably can't-- unless you're a bank lobbyist, a finance lawyer or a nerdy blogger. And the bank lobby loves it that way, because there are only a few nerdy bloggers out there, even fewer financially literate mainstream reporters, and hundreds and hundreds of bank lobbyists. Here are the critical passages from page 6 of the ISDA letter, and page 4 of the ABA letter. I'll explain why it's so destructive below. ISDA:

Financial" risks are "commercial risks." The dictionary definition of "commercial" is "of, pertaining to, or characteristic of commerce." The term "commercial risk" should be defined against this background.

ABA:

It is very important for our members that the term "commercial risk" be interpreted broadly enough to include financial risk for depository institutions.

In the years leading up to the financial crash of 2008, banks could trade complex derivatives completely in the dark. If Goldman Sachs wanted to make a deal with AIG, all they had to do was make a phone call (or just as frequently, type out an AOL instant message). No government regulator looked at this trade, and nobody in the market evaluated whether either party could possibly make good on it.

And so AIG built up literally trillions of dollars in exposure to the housing market by betting money it didn't have with big Wall Street banks. And banks, eager to dump the risks posed by crappy mortgages onto AIG, didn't bother to figure out if AIG could ever possibly make good on all of its derivatives contracts.

Ultimately, AIG got burned badly, and the banks came crying to Washington for help. The Federal Reserve acquiesced, and funneled billions of dollars to AIG, which in turn went directly to major banks—most notably Goldman, which scored $12 billion from the first round of payments alone.

One way to fix this problem is to give the market some scrutiny over derivatives trading—the same kind of scrutiny it has over ordinary stock trades. This is a minimum step—as we've seen with flash crashes and naked short sales, market scrutiny isn't a guarantee against fraud, abuse or excess. But it's a lot better than nothing.

So the Wall Street reform legislation required all derivatives contracts to be traded through what's known as a "central clearinghouse." This is basically a third company that serves as an intermediary between the two firms that want to trade—the way the New York Stock Exchange stands between two companies trading a stock.

When Goldman calls up AIG, the clearinghouse forces both companies to post margin on the trade, verifies their ability to make good on it, and agrees to foot the bill of one party can't pony up.

But the big banks, operating primarily through the U.S. Chamber of Commerce, were able to carve-out a big loophole in this process. Surely not every trade needed to be centrally cleared, they argued. Plenty of farmers and manufacturers ink derivatives contracts in order to insure themselves against ordinary, non-financial commercial business risks. If a farmer is worried that the price of wheat might go up or down, he can go to JPMorgan Chase and ink a trade. The farmer pays JPMorgan a few dollars every month, and if the price of wheat goes too high or too low, JPMorgan agrees to pay the difference to the farmer. We don't want to punish poor farmers for excesses committed on Wall Street.

This argument was always stupid for lots of reasons, but it ultimately won the day. "End-users" like airlines and farmers that wanted to hedge "commercial risks" were not required to trade through a clearinghouse.

Fast forward to September 20, and the bank lobby is trying to pull a fast one by redefining the word "commercial." The bank lobby is trying to convince regulators that the business risks of financial institutions—banks, hedge funds and companies like AIG—ought to count as "commercial risks." If the bank lobby succeeds, they'll allow all kinds of huge financial firms to keep their derivatives trading in the dark, and leave the economy open to another AIG-style calamity.

That would directly benefit major Wall Street banks like Goldman Sachs, JPMorgan Chase and Bank of America. Remember, it's not just the farmer who avoids the clearinghouse when she hedges a "commercial" risk—it's the trade itself. That means that the bank on the other side of the trade gets to deal off the grid, as well. So long as the too-big-to-fail Wall Street banks conduct their riskiest, most abusive deals with hedge funds, insurance companies or anybody except another too-big-to-fail Wall Street bank, they could keep their trading totally secret. That is exactly what happened with AIG, and with these two letters, the bank lobby is pressuring regulators to maintain that status quo. If the TBTF derivatives dealers get into trouble again, after all, they can always come to taxpayers for a bailout, just as they did with AIG.

So there you have it. A full 900 words of blogging to explain why a single word in a letter from bank lobbyists threatened to undo one of the most significant accomplishments from the Wall Street reform bill.

There are literally hundreds of rules like this coming. And Republicans are already vowing to hamstring regulators if they gain control of the House next year.

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