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Sec. 608 -- No Proxy Bailouits for Derivatives Affiliates

June 18, 2010 - by Donny Shaw

For those willing to step into the weeds and follow what the financial reform conference committee is going to do next week on derivatives reform, this from Zach Carter at Alternet is an important addition to what we should be paying attention to:

To kill off the subsidies, Lincoln’s plan—known as “Section 716″ on Capitol Hill—would force banks to move their derivatives dealing operations into an independently capitalized affiliate company. That affiliate would have no access to taxpayer perks, and would not be able to use cheap Fed loans and deposits to book artificially inflated profits—and by extension, bonuses—on inherently risky derivatives deals.

But for this plan to work, the bank—a company with access to taxpayer perks—can’t be able to simply bail out its derivatives affiliate when it gets into trouble. Those bailouts would ultimately be financed by taxpayer subsidies, rendering the whole point of the Lincoln plan meaningless. There are already laws on the book that limit transactions between banks and their affiliates (for wonks: Sections 23A and 23B of the Federal Reserve Act), but the laws are weak. Fortunately, Section 608 of the Wall Street overhaul that cleared the Senate significantly strengthens those rules.

Current law only keeps banks from bailing out their affiliates with traditional loans. If they want to use a more complicated transaction, like, say, a derivative, to salvage the affiliate, they can. The Senate bill tightens this language, barring banks from bailing out their affiliates with both securities lending and derivatives operations.

Thanks to lots of grassroots action and some big endorsements from regional Fed chiefs and the like, Sec. 716, the “prohibition against federal government bailouts of swap entities,” actually stands a chance of making it into the final bill. 716’s biggest opponent at this point is the White House, which, publicly, is saying that the section is “not a priority,” while privately lobbying conferees to have it removed. With the momentum behind 716, it’s important to watch for any compromises or other corresponding actions form the conference committee that would effectively gut it while letting 716 technically stay in the bill. This 608 issue sets up a perfect opportunity for any conferees who want to craft a 716 loophole.

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