Congress: No Christmas Gifts for Wall Street

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This post first appeared at The Baseline Scenario blog.

(Credit: Charina Nadura/Moyers & Company)

(Credit: Charina Nadura/Moyers & Company)

Editor’s Note: Dangerous bets placed using complex financial derivatives were an important part of what went wrong in 2007-08. And part of this damage was done by supposedly sophisticated financial firms, such as Citigroup. The Dodd-Frank financial reforms attempted to limit this behavior — and reduce these risks to the broader economy — by restricting the extent to which a firm like Citigroup could use its federally insured bank as a way to fund some kinds of bets using derivatives. This so-called “push out” (of derivatives from the insured bank) limits Citigroup’s ability to take big risks and affects other mega-banks in the same way. Not surprisingly, Citigroup and other Too Big To Fail banks want to return to what for them were the good old days — when they could take any kind of risk they wanted, so they get the upside and the rest us are stuck with the massive and awful downside risks.

Section 716 of the Dodd-Frank financial reform act requires that some derivative transactions be “pushed-out” from those part of banks that have deposit insurance (run by the Federal Deposit Insurance Corporation) and other forms of backstop (provided by the Federal Reserve). This is a sensible provision that, if properly implemented, would help keep our financial system safer, protect taxpayers and reduce the likely need for bailouts.

Now, at the behest of the biggest Too Big To Fail banks and as part of the House’s spending bill (to be voted on today or in coming days), this “push out” requirement is on the verge of being repealed. Democrats and Republicans should refuse to vote for the spending bill as long as it contains this requirement.

This is not a left vs. right issue. It is a fundamental systemic risk issue, on which people across the political spectrum who want to lower those risks can agree – Section 716 should not be repealed. In fact, some of the sharpest voices on this issue come from the right.

In a statement on Tuesday, Thomas Hoenig, appointed by the Republicans to be Vice Chair of the FDIC, said:

“In 2008 we learned the economic consequences of conducting derivatives trading in taxpayer-insured banks. Section 716 of Dodd-Frank is an important step in pushing the trading activity out to where it should be conducted: in the open market, outside of taxpayer-backed commercial banks. It is illogical to repeal the 716 push out requirement.”

And on Tuesday evening, Senator David Vitter (R-LA) put the issue in its proper broader context,

“Ending too big to fail is far from over. Before Congress starts handing out Christmas presents to the mega-banks and Wall Street – we need to be smart about this. Removing these risky derivatives that aren’t even necessary for normal banking purposes is important, and Members of Congress need to rethink repealing this critical provision.”

The effort to repeal Section 716 comes primarily from the largest banks (and some say from Citigroup), who claim that these restrictions are somehow onerous or unreasonable. These arguments have no merit.

Under Section 716, interest rate swaps, foreign exchange derivatives and cleared credit derivatives can remain on the balance sheet of the insured bank. This is almost all derivatives. And hedging of risks by banks using derivatives is most definitely allowed.

The push out applies most notably to uncleared credit default swaps (CDS), equity derivatives and commodity derivatives. (See Tom Hoenig’s statement for a succinct and precise statement of the issues.)

The point of the push out is to get these potentially high risk swaps away from the insured part of the bank – and away from the explicit backstop provided by deposit insurance (and ultimately by the taxpayer).

The big banks (such as JP Morgan Chase and Citi) are actually a complex collection of separate companies – only one of which is typically an insured bank. That insured bank is regarded as a better credit (i.e., lower risk) by people in the market precisely because of the federal government-run deposit insurance. Like all better credits, those banks get to borrow at lower costs.

If these swaps are pushed out from the insured part of the bank, these speculative derivative positions will be priced by the market based on their actual risk – not mispriced due to the backing of taxpayers. Thus the derivative activities of these four banks, conducted by their uninsured subsidiaries, will become more expensive to fund.

Really this is just taking the state out of subsidizing some of these particularly high risk derivatives. That would be no more than reintroducing the market and market pricing of credit risk.

The four largest banks (according to the Office of the Comptroller of the Currency, OCC) conduct more than 93 percent of all derivatives activities in the US. (That is using “total banking industry notional amounts”; if you prefer net current credit exposure, NCCE, the same banks are 82 percent of the industry.) The repeal of section 716 is for them.

Remember when JP Morgan Chase lost more than $7 billion in its so-called “London Whale” trade? That was a high risk, highly leveraged proprietary bet involving complex Credit Default Swap indices. And JP Morgan Chase’s bet, which reportedly had a notional value of more than $1 trillion, was funded in part with insured deposits. (Publicly available information indicates that JP Morgan Chase – just like Citigroup – has the vast majority of its derivatives activities run out of the insured bank.)

So the vote this week is simple. Democrats and Republicans should vote to, at least partially, bring back the market forces – by rejecting the repeal of Section 716. End state subsidies for these mega-banks’ derivatives activities.

This is not what Citigroup, JP Morgan, Bank of America or Goldman Sachs wants, of course. They want government insurance and their derivatives dealing to be subsidized by taxpayers, on the most favorable terms possible: it lowers their costs and increases their profits. As a result, Too Big To Fail banks’ executives and traders get the upside when things go well; and when things go badly, the downside is someone else’s problem.

Or, as Dennis Kelleher of Better Markets puts it,

“If Wall Street gets the upside in big bonuses from its high-risk derivatives deals, then it should also have to pay the downside for any losses.”

Remember that Citi’s lobbyists and their colleagues worked long and hard during the 1990s to relax all meaningful limits on their ability to take big risks. And the firm subsequently hired top Clinton-era officials to guide their economic and political strategy in the 2000s. This ended very badly – with the near-failure of Citigroup, multiple taxpayer bailouts, and a deep recession from which, six years later, we have not yet fully emerged. Citigroup was at the epicenter of what went wrong on Wall Street in 2007-08 and received more bailouts than any other single institution, almost $500 billion.

In the 1990s there was a Citigroup-inspired consensus in favor of deregulation. That legislative push proved to be a mistake, but at least it was done in the open. Now similar forms of deregulation – encouraging excessive risk-taking – are being pursued through back-room deals, with no hearings, and no debate.

To start again down the same path – and at the instigation of the same set of banks – is pure folly.

And to do it through this underhand process shows you that the big banks have no intellectual arguments left on their side. All they have to offer now is the prospect of large campaign contributions.

The views expressed in this post are the author’s alone, and presented here to offer a variety of perspectives to our readers.

Simon Johnson is a professor at MIT, a senior fellow at the Peterson Institute for International Economics and a former chief economist at the International Monetary Fund. He was recently named a “Main Street Hero” by the Independent Community Bankers of America (ICBA). Follow him on Twitter: @baselinescene.

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