Conservatives Agree Derivatives Dangerous... So Get on Board with Regulation!

I've noted previously that we really need to reform the derivatives market. Unregulated derivatives trading helped get us into the current recession. Even arch-conservative blogger John Walker agrees that unregulated derivatives are dangerous. Walker cites this article from the Washington Times (you know, the conservative Moonie paper) that refers to derivatives as "the fiscal equivalent of a weapon of mass destruction" and chides the "generously lubricated lobbyists for the unrestricted, unsupervised derivatives markets [who] tell congressional committees and government regulators to butt out."

Of course, Walker's ideological blinders are screwed on so tightly that he doesn't actually call for reform; he just uses the article to reinforce non-sequiturally his delusion that President Barack Obama is a lying communist. Never mind that President Obama is advocating derivatives reform. Never mind that Congressional Dems are pushing for derivatives reform harder than Walker's GOP.

I can't help wondering if Mr. Walker would rather see financial reform fail and the whole economy collapse again, just so he could fling more insults at the President. Sigh.

Shake off those blinders—support the President's call for regulating derivatives!

No More "Too Big to Fail": Cap Bank Assets at $100 Billion

Troy Jones, Bill Fleming, and I are working on building some consensus toward serious, effective financial reform. The Senate Ag Committee, community banks, and I maintain that regulating derivatives is a key part of that reform. And if, as finance professional Jones contends, derivatives are too complicated for most people to understand, that strikes me as all the more reason we should restore some stiff regulations on them.

But just like our Republican and Democratic counterparts in the Senate, Troy and I may be a lot closer to agreement on financial reform. Jones wants to break up the megabanks so no one is "too big to fail." I'm all about that idea. So is Robert Reich, who lists these three big things the pending financial reform bill really really needs to do:

1. Require that trading of all derivatives be done on open exchanges where parties have to disclose what they’re buying and selling and have enough capital to pay up if their bets go wrong. The exception in the current bill for so-called “unique” derivatives opens up a loophole big enough for bankers to drive their Ferrari’s through.

2. Resurrect the Glass-Steagall Act in its entirety so commercial banks are separated from investment banks. The current bill doesn’t go nearly far enough. Commercial banks should take deposits and lend money. Investment banks should be limited to the casino we call the stock market, helping companies issue new issues and making bets. Nothing good comes of mixing the two. We learned this after the Great Crash of 1929, and then forgot it in 1999 when Congress allowed financial supermarkets to do both.

3. Cap the size of big banks at $100 billion in assets. The current bill doesn’t limit the size of banks at all. It creates a process for winding down the operations of any bank that gets into trouble. But if several big banks are threatened, as they were when the housing bubble burst, their failure would pose a risk to the whole financial system, and Congress and the Fed would surely have to bail them out. The only way to ensure no bank is too big to fail is to make sure no bank is too big, period. Nobody has been able to show any scale efficiencies over $100 billion in assets, so that should be the limit [Robert Reich, "A Short Citizen's Guide to Reforming Wall Street," blog, 2010.04.20].

Now if we can get Congress to listen to a bipartisan coalition of Troy Jones and Robert Reich, we've got a winner of a bill!

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Read more!

• Mr. Jones forwards this NYT article noting growing support among Dems and the GOP for breaking up banks. It also notes that, since the 2008 credit collapse, our policies have made the banks that are too big to fail even bigger. The six biggest banks—Bank of America, Citigroup, JPMorgan Chase, Wells Fargo, Goldman Sachs and Morgan Stanley—now have assets equal to 63% of the U.S. GDP, compared to 17% back in 1995.
• Jones also forwards this fruitful series of NYT essays from some folks with serious econ chops on what's missing from the financial reform bill.
• Robert Reich also notes that Senator Dodd's bill does go the wrong direction, giving big banks even more advantages over small banks. Let's fix that! Remember: community banks are the best place for your business!
  

Derivatives: Less Theory, More Facts... and More Capitalism, Please!

In response to my Monday post on derivatives reform, Troy Jones appears to assert that unregulated derivatives are good for the economy, providing "lubrication to the system's liquidity."

Lubrication, heating oil...

Sean Cota runs a family-owned heating oil business in Vermont. He says using derivatives purely to speculate on the price of oil has hurt his business and consumers' wallets.

SEAN COTA: We calculate that this unregulated market has encouraged speculative fervor that costs about a $1 per gallon.

[Brett Neely, "Businesses Differ on Derivatives Reform," Marketplace, 2010.04.20]

Neely's report pokes some other holes in the theoretical capitalist defense of unregulated derivatives, which seems about all the GOP can muster as it fights this latest really good idea from Democrats. Neely notes that derivatives were "boring and safe" for centuries. Deregulation happened only in 2000. Hmm... credit was plenty liquid in the twentieth century, wasn't it?

Neely also notes that, under deregulation, derivatives have operated in a distinctly uncapitalist fashion. Outside of exchanges, banks set prices, keep them private, and prevent buyers from getting information about the risk involved. Capitalism requires a free flow of information right alongside capital. But the big five banks that control most of the derivatives don't want us to get information and compare prices:

Because there's not efficient pricing [in the current system], these big five derivatives dealers can really charge through the roof for these derivatives products and that's one big reason why they've been so profitable [David Min, quoted in Neely, 2010].

Neely finds a good capitalist from the Chamber of Commerce to defend unregulated derivatives:

The whole point of the exercise is to transfer that risk somewhere else so that you can be in the business of producing beer or making widgets or whatever it is you do [David Hirschmann, quoted in Neely, 2010].

Hold on: transfer the risk?! I thought risk was an inherent and necessary part of being in business. You don't get to make beer or widgets without risk. If I choose to produce art or make speeches for a living, I don't get to transfer my risk to someone else. I assume the risk that people just won't buy enough of what I'm selling to keep me in paint and shiny shoes... right?

Perhaps I misunderstand capitalism. But the more I listen to conservative arguments against regulating derivatives, the more I hear a vague theoretical declarations that ignore the facts of what unregulated derivatives have wrought. In practice, unregulated derivatives look like an inherently anti-capitalist financial product, one that withholds the information buyers need to make good choices, removes the risk the market needs to check unwise actions, and threatens the stability of the free market economy.

"Boring and safe"—that's what derivatives regulation gets you. And after the excitement of seeing your mutual funds wiped out in the recession, couldn't you use some boring and safe?

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Update 17:02 CDT: Senator Grassley from Iowa joined 12 Dems on the Senate Ag committee in approving derivatives regulation today. Grassley is no Olympia Snowe; his vote may be a sign that Republicans see it's time to stop saying no to ideas that will be good for the economy.

Derivatives Reform: You Want This!

With health insurance reform now in the win column, Congress and the President are turning to financial reform. There will be a lot of moving parts to this legislation—you just can't govern the world's biggest economy on slogans and one-page bills. Among the essential moving parts: derivatives reform.

President Obama is vowing to veto any financial reform legislation that does not include regulation on deriviatives. His chief economic advisor, Christina Romer, backs him up:

What is needed is a new set of rules of the road for our financial system, greater accountability for Wall Street, and increased protections for consumers. Those rules include a comprehensive regulatory framework where capital and liquidity requirements control excessive risk-taking and where regulators consider risks to the system as a whole and not just to individual institutions. They involve putting complicated financial products such as derivatives onto exchanges and into clearinghouses so that risks are known and values are clear [Christina D. Romer, "Back to a Better Normal: Unemployment and Growth in the Wake of the Great Recession," address to the Woodrow Wilson School of Public and International Affairs, Princeton University, 2010.04.17].

Now before my conservative friends buy into the Senate Republicans' political line that regulation is bad, consider why derivatives matter. The collapse of credit default swaps, one flavor of derivatives, forced us to bail out AIG to the tune of $180 billion. That was arguably a greater intrusion on the free market than any specific regulation.

Five banks, including our friends at Citicorp, constitute "a kind of cartel that controls all the trading and information" on derivatives. That's not a free market when a handful of players with vested interests monopolize information.

Regulation of derivatives doesn't put anyone out of business. It simply puts this particular financial "product" on the same footing as stocks, which are traded quite happily and successfully on open, regulated exchanges. Regulation hasn't killed the stock market; it has made the market healthier and safer. Regulation would do the same for derivatives. Secretary Geithner explains:

Transparency will lower costs for users of derivatives, such as industrial or agriculture companies, allowing them to more effectively manage their risk. It will enable regulators to more effectively monitor risks of all significant derivatives players and financial institutions, and prevent fraud, manipulation and abuse. And by bringing standardized derivatives into central clearing houses and trading facilities, the Senate bill would reduce the risk that the derivatives market will again threaten the entire financial system [Secretary of the Treasury Timothy Geithner, "How to Prevent America's Next Financial Crisis," Washington Post, 2010.04.13].

Regulating derivatives shifts risk back to where it belongs in the market: on informed investors who can cover their bets.

If you don't like bailouts, if you don't like recessions, if you don't like losing your job because Wall Street fat cats crashed the global economy, then you do like derivatives regulation and the full financial reform package working through Congress.

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To understand derivatives, try this explanation from Prof. Michael Greenberger. The professor notes that when AIG went bust, it had over 20 divisions. On September 16, 2008, AIG's regulated divisions were humming along nicely with $20 billion in reserves. AIG's one derivatives subdivision was not regulated, held no reserves, issued insurance policies worth double the company's value, and sunk the company.