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Will the Agriculture Committee Hand Wall Street a Big Win on Derivatives?

April 5, 2010 - by Donny Shaw

Derivatives, those obscure financial products built off the value of other assets, have their historical roots in agriculture. Farmers and investors would place bets against the harvest as a way to hedge against the uncertainty involved in making your living off of raising food. The derivatives market is now a several hundred trillion dollar, highly complex financial market, but the congressional agricultural committees still hold legacy jurisdiction over regulating it.

TNR’s Noam Scheiber has a great piece on the state of financial reform in the Senate, describing an emerging strategy to put some relatively strong consumer protections in the bill while giving Wall Street much of what they want in areas that the public isn’t paying attention to. Derivatives reform — or the lack therof — is likely going to be the area where Wall Street gets their biggest win, and the Senate Agriculture Committee is set up to be the driving forces behind delivering it.

I’m going to excerpt a pretty big section of the article here — I hope you’ll read it and then click through to read the full article:

The logic becomes even more compelling once you home in on particular issues. For example, one of the most important but least understood parts of the financial reform bill relates to derivatives, which are essentially bets on the prices of other assets, like stocks and bonds. The credit default swaps that brought AIG to the government’s doorstep are probably the most famous example of the trouble-making potential of this financial instrument. AIG’s derivatives portfolio was largely a bet on bonds backed by mortgages. When the mortgages took on water, the bet left AIG on the hook for billions in losses, pushing the company to the brink of bankruptcy.

As written, the Dodd bill would require buyers and sellers of derivatives to “clear” them. That means each side would technically trade with a middleman—the clearinghouse—to whom they’d hand over enough cash to cover bets that go bad. If AIG had imploded, it would have stiffed the companies on the other side of its derivatives bets, who might in turn have stiffed the companies they’d bet with, in an ever-expanding chain of financial destruction. The hope is that clearing will prevent problems at a future AIG from spreading this way, so that the government doesn’t have to intervene.

For the last several months, the big banks, who make billions of dollars trading derivatives, have tried to arrange it so that these proposals would apply to as few transactions as possible. Their efforts have been somewhat successful—the financial reform bill that passed the House in December featured a reasonably broad exemption to the new regulations (though the industry still has its share of gripes). But the language Dodd moved through his Banking Committee last month is significantly tougher, and the administration has expressed its support.

And, yet, when you talk to industry representatives, they don’t appear overly troubled by the recent turn of events. Most continue to regard the derivatives provision in Dodd’s bill as a placeholder, which will almost certainly be nudged aside by a compromise negotiated by Democrat Blanche Lincoln and Republican Saxby Chambliss. (The two senators run the Agriculture Committee, which shares jurisdiction over derivatives.) As one lawyer involved in the derivatives industry told me last week, “If they try to push the Dodd bill as currently written on derivatives—it can’t fly.”

What explains the serene confidence? “Derivatives is the tail on this dog,” the lawyer continued. “It’s not what’s going to drive the bill through Congress. Nor is it the filibuster point. Other stuff makes a lot more noise.” The bottom line, this person concluded, is that voters just aren’t very invested in the details of derivatives reform, and so it’s hard to believe the Democrats will be, too: “Words on the page are not that critical to the public. … The public just wants to see something done here. … To some extent, passing a bill [whatever the details] will be marketed as a success.”

Last week, I posted about the significance of handing derivatives reform over to the Agriculture Committee and their conservative Chair and Ranking Member, and what a “win” on derivative reform for Wall Street would look like.

Image from Pinachina used under a CC license.

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