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Derivatives Reform Failure and the Risk of Future Bailouts

April 12, 2010 - by Donny Shaw

Benjamin Sarlin has a great piece at the Daily Beast on the state-of-play of derivatives reform now that it’s moving under the jurisdiction of Sen. Blanche Lincoln [D, AR] and the Agriculture Committee.

He has a Lincoln staffer is on record saying that the derivatives bill she’s writing, which will be dropped in the next couple weeks, will at least require all derivatives to be traded publicly on exchanges. That’s a relatively big deal in that it tells us where we should be watching for possible derivatives dealer (a.k.a. the big banks) giveaways, namely in clearing exemptions and margin requirements for swaps that are exempt from clearing. We already know that Lincoln is planning to put exemptions for “end-users” in her bill. If it’s anything like the House bill, up to half of all swaps could be exempt from clearing.

The Dodd bill that the Lincoln bill would be replacing has new margin requirements for all derivatives that would be exempt from clearing in order to offset risks and encourage more trading to be done through clearinghouses. If the Lincoln bill, on the other hand, couples clearing exemptions with no margin requirements on swap trades that are exempt from clearing, it runs the risk of perpetuating the “too interconnected to fail” problem. Large financial institutions could use the clearing loopholes to get lots of skin in the derivatives game without having to put up any collateral, and if they start to falter they could put a big part of the economy on the other end of their derivatives obligations at risk, necessitating a governemnt bail out.

Two back-to-back paragraphs from the Sarlin piece describe the possibility:

“The basic story is that if you exempt end users you have created a loophole large enough to drive a truck through,” Dean Baker, co-director of the Center for Economic and Policy Research, said. Take for example, Enron, an end-user that was not a financial institution but ended up costing investors billions of dollars after peddling energy-based derivatives that became worthless when it went under.

“The danger in the future is that we don’t know who the next AIG could be,” said Robert Litan, a senior fellow at the Brookings Institute. “If a company falls on hard times and can’t honor its derivatives contracts, and hasn’t posted margins, then the argument will be made when it goes down the tubes that all these people with contracts will lose money and we can’t allow that, so it we’ll have to bail them out.”

By the way, Robert Litan has a great new paper out on derivatives reform entitled “The Derivatives Dealers’ Club and Derivatives Markets Reform: A Guide for Policy Makers, Citizens and Other Interested Parties.” It’s a great intro to derivatives reform and the many challenges it faces in Congress and beyond.

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