Bloomberg has an excellent story on the origins of Blanche Lincoln's disastrous swaps proposal (the infamous "Section 106") — Bloomberg: How ‘Hard to Fathom’ Derivatives Rule Emerged in U.S. Senate. Short version:

The idea arose from a mix of policy debate, campaign politics and personal relationships -- and little consideration of the business or economic implications, according to interviews with Senate aides, administration officials and industry lobbyists.
Read the whole article. Oh by the way, Paul Volcker has now also come out against Section 106. Sheila Bair penned a letter to Lincoln sharply criticizing Section 106 last week, and the Fed circulated a memo on the Hill a couple weeks ago arguing that Section 106 should be deleted.

Of course, it looks like the usual suspects on the left will still loudly support it, because right now, pretending to fight Very Important battles with Wall Street on financial reform is really all they care about. Unfortunately, "experts" like Michael Greenberger and Robert Reich have already come up with absurd/dishonest arguments for why this is actually "real reform" that the left should fight for, and why anything less would be a give-away to Wall Street. They should be embarrassed.

Greenberger, for instance, is apparently willing to claim, with a straight face, that major nonbank swap dealers "would not [be] shadow banks." I kid you not. That's how far defenders of Section 106 have to twist their logic. And Reich arguably one-upped Greenberg yesterday with this doozy:
Senator Blanche Lincoln, Democrat of Arkansas, has pushed an amendment that would force big banks to spin off most of their derivative businesses — bringing derivatives into the open and insulating them from the kind of proprietary trading that can cause so much havoc. But the Administration thinks Lincoln is going too far and has instructed its allies in the Senate not to go along. Lincoln should stick to her guns.
Wow. That's just incoherent. Reich apparently thinks that pushing the vast majority of swaps away from banking regulators would be "bringing derivatives into the open." That claim literally makes no sense. Also, it's 100% untrue that Section 106 would "insulate" banks from proprietary trading. The whole point is that Section 106 doesn't distinguish between prop trading and market-making. It bans banks from doing both. Reich clearly has no clue what Lincoln's Section 106 proposal is even about — and yet he's already declared that failing to support it would be "pandering to Wall Street."

Look, this isn't difficult. Swaps are a critical part of modern banking. Just like normal commercial lending requires banks to serve as intermediaries between savers and borrowers, the swaps market also requires intermediaries (known as dealers, or market-makers). These intermediaries borrow short and lend (through swaps) long; they are susceptible to runs; and their disorderly failure can cause severe collateral damage to the real economy. Pretending that swap dealers aren't engaged in an important banking function by refusing to call them "banks" is not just delusional, it's also dangerous. And yet this is what Blanche Lincoln's Section 106 proposal aims to do.

Period.

21 comments:

Matthew said...

I understand your point, but why do we need swaps at all? It seems to me that they are largely about people making trade-offs that they don't really understand, or hiding exposures, or making bets that they could make using other instruments, where the risks might be more explicit.

So what is the legitimate value-added by a swaps market? I'm not saying there isn't any, but I do wonder what it is.

Cetamua said...

I second Matthew's question: Why are swaps beneficial to the real economy?

I'll go further by assuming they're beneficial. In this case, and taking into account what you wrote:

"These intermediaries borrow short and lend (through swaps) long; they are susceptible to runs; and their disorderly failure can cause severe collateral damage to the real economy."

What would be your legislative proposal to minimize the risk of disorderly failure? I read a lot of criticisms about how clueless Senators and Congresspersons are, but the same critics fall far short when it comes to cogent proposals.

With your background, I would ask you to elaborate further; inquiring minds really want to know.

Thank you

Y = X said...

You wrote:

Swaps are a critical part of modern banking. Just like normal commercial lending requires banks to serve as intermediaries between savers and borrowers, the swaps market also requires intermediaries (known as dealers, or market-makers).

Is the modern banking system worth preserving? Do the benefits of swaps outweigh the occasional systemic crash they seem to induce?

Perhaps we are a point of no return and getting rid of swaps would cause too great a disruption. I'm with Mathew and Cetamua, why is it a system worth preserving? Why is it worth preserving a system in which a person make $20 million bonuses without making, from my perspective, a tangible contribution to the whole of society? (I lean toward socialism so my views are skewed by this.)

Thank you for any responses to my questions or Cetamua or Matthew.

JCH said...

Swaps did not induce the financial crisis. Subprime lending did that.

Swaps turned prudent "you don't qualify for a loan" bankers into "hey, everybody is qualified for loans" socialists.

Y = X said...

JCH,

Your comment appears to be contradictory. You say swaps didn't cause the crisis but were the mechanism that allowed bankers to throw caution to the wind. Is there a meaningful difference between causing the crisis and being the mechanism that allowed it to happen?

rootless_e said...

my question too. Swaps seem like methods for evading sensible rules about insurance.

As for Robert Reich, he's in the history books as the Secretary of Labor who presided over the adoption of NAFTA. Sucks to be him.

JCH said...

Some day a professor will write a book in which he proves that swaps/derivatives lessened the damage caused by the credit crisis. Progressives will howl in disbelief.

IMO, the professor will be right.

Anonymous said...

"swaps" --- whether that means interest rate swaps, credit default swaps, FX swaps, commodity swaps, whatever, are beneficial to the real economy because they allow corporates (financial and non-financial) to HEDGE RISK. interest rate risk, credit risk, currency risk, commodity price risk, whatever. hedgers need people to take the other side of their trades, and that is either market makers or speculators. you cannot ban risk transfer activity because you find it distasteful --- it's essential to the real economy.

JCH said...

Anon 8:45 pm, if entities with a risk problem they would normally want to hedge could not hedge, how would that manifest itself in the "real" economy?

I think that is what they do not understand, or do not believe. That hedging has an actual purpose in the "real" economy.

They appear to think this is simply gambling. That Coca Cola, for instance, which has coin-operated machines in almost every country in the world (talk about gambling), is essentially betting tens of millions on red just for the MBA entertainment heck of it.

Anonymous said...

Anon 8:45 pm, if entities with a risk problem they would normally want to hedge could not hedge, how would that manifest itself in the "real" economy?

Assuming that's not rhetorical...

Higher volatility in revenues and profits => higher volatility in earnings => higher volatility in asset prices => reduced incentives to invest (because of higher risk premia and increased uncertainty), higher volatility in 401Ks, lower consumer spending (via a reduced wealth effect), lower growth...etc.

Anonymous said...

The GOP meme that subprime lending caused the credit crisis satisifies the Limbaugh/Palin/Gingrich types who need to blame everything on minorities and the alleged policies of the Carter Administation.

The fact is that Bear Stearns, Lehman, AIG did little, if any, sub prime lending. These firms were massive participants in the credit derivatives markets however.

Also, there is a major difference between interst rate derivatives and credit derivatives.

A distinction lost on those who yearn still yearn for George W. Bush.

JCH said...

I'm a liberal Democrat. I've never voted for a Republican in my entire life.

The Republican meme is about CRA lending.

Anonymous said...

JCH,

Can you explain why Coca Cola would need to buy (or sell) a CDS on ABS to "hedge" anything?

If subprime lending caused the credit crisis, why was BSC in near default and LEH went bankrupt? Derivatives had nothing to with anything?

I'm sure that you are one of those 'liberal Democrats' that gets your news from Fox, thinks W became President on 9/12/2001 and left office in January 2007.

And the Jimmy Carter and Barney Frank bear all the blame for the credit crisis which was mitigated by the efforts of Hank Paulson, Chris Cox and Sarah Palin through the use of credit derivatives.

Howard Lothrop said...

Quick example of why we need swaps. Bank depositors generally use short maturity (or even overnight) deposits. Borrowers want long term fixed rate loans. So a bank has quick repricing liabilities (deposits) and long repricing assets (loans). That's a recipe for disaster. We saw it before. It was called the S&L crisis.

Banks use pay fixed interest rate swaps to offload interest rate risk of long term fixed and get short floating rate (libor). Don't want swaps? No problem. Just kiss fixed rate loans goodbye.

Or, look at the converse. Insurance companies (or pension funds) have long liabilities (long time before we die, at least we hope so)but can only get relatively short avg life assets. They use interest rate swaps to lengthen assets to better match liabilities.

Problem wasn't interest rate swaps. Problem was CDS (unhedged/poorly hedged and priced)combined with lowered restrictions on short selling. They allow you to buy CDS protection then spark financial run by aggressive short selling. Becomes self-fulfilling prophecy.

It's like buying fire insurance on your neighbor's home and then letting you pour gas around the foundation while giving neighborhhod kids matches to play with. Simply a poor policy/regulatory decision.

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