Swaps Fight Is Almost Over—And Banks Are Winning

Banks yesterday won an important victory over the part of the financial reform package they most feared—and almost no one noticed.

Senator Blanche Lincoln is considering a “compromise” that will neuter her proposal to ban banks from trading derivatives by including a long delay before requiring any change to the swaps business, allowing banking regulators discretion about implementing the provision, permitting special derivatives entities to operate inside of federally supported bank holding companies, and pre-authorizing federal bailouts of the derivatives entities if they blow themselves to financial smithereens.

Lincoln’s spokesperson says the derivatives proposal remains “a strong provision,” which might make you think it remains a strong provision.

Think again.

Under the proposed compromise, any spin-out of swaps desks will be phased in over a two-year period. During that time, federal banking agencies will be tasked with considering the impact of the measure on mortgage lending, small business lending, jobs, and capital formation.

Those vague and open-ended considerations will provide wiggle-room for the federal banking agencies to avoid implementing the new swaps rules.

Make no mistake about what is going on here. The swaps provision is being transformed from a mandatory ban into something over which banking regulators have discretion. And the banking regulators—from Fed chair Ben Bernanke, to FDIC chief Shelia Bair, to SEC head Mary Schapiro—oppose the ban on swaps altogether. Given wiggle room, they will wiggle right past Senator Lincoln rule.

Government Regulation
Government Regulation

Even if the new rule were somehow to survive the wiggle of the regulators, Lincoln’s compromise also allows the banks to continue operating swaps desks so long as they are separately capitalized. To put that in perspective: the failed Bear Stearns hedge funds and the Citigroup SIVs that collapsed at the start of the financial crisis were also separately capitalized. But that capital proved inadequate, and eventually they had to be “bailed out” by their parent companies.

And the losses at the SIVs and the hedge funds eventually became taxpayer liabilities when the government stepped in to prevent the collapse of Citi and backstop Bear’s losses.

If a new swaps entity gets into trouble, guess what will happen?

It’s not for nothing that some on Wall Street have already nick-named these swaps spin-offs "Swaps & Hedging Independent Trading Companies."

The swaps spin-offs don’t even have to be swallowed by their parents to become taxpayer liabilities. The Lincoln compromise allows the swaps entities to receive “broad based federal assistance.”

Translation: if the government starts bailing out Wall Street again, the swaps spin-offs get a place at the trough.

Why did Lincoln give up so quickly, even before the Capitol Hill conference began formally considering her provision? The conference to reconcile differences between the bills passed by the House and Senate probably won’t even get around to considering the swaps provision until next week. What’s the rush to compromise?

Keep in mind the Lincoln became a harsh critic of derivatives trading in the face of a primary challenge from the left. Her victory in the primary took away the pressure to fight for an effective derivatives ban. All she needs now is the appearance of a “strong provision.”

The six Wall Street banks that dominate the derivatives trading business are still saying they oppose the provision. But somewhere Jamie Dimon, the JP Morgan Chase executive who has personally been lobbying against the provision, is probably smiling. The banks have all but won this fight.