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Obama's Treasury Dept Working To Defeat Derivatives Proposal 'Of Utmost Importance' To Reforming Wall Street

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A Senate proposal to force banks to shed their lucrative yet risk-laden derivatives units -- which is vehemently opposed by Wall Street -- is gaining steam, picking up the support of some regional Federal Reserve chiefs with more on the way.

Yet President Barack Obama's Treasury Department, led by Timothy Geithner, continues to oppose the measure, Senate aides say, who add that Treasury is supporting Wall Street over Main Street by opposing the measure considered of "utmost importance" to financial stability.

"It shows the access of the major Wall Street banks in the Treasury Department in spades," one Senate aide said on the condition of anonymity. Assistant Treasury Secretary for Financial Institutions Michael S. Barr is said to be leading Treasury's efforts.

Senate aides say that more letters of support from other regional Fed presidents are on the way.

Treasury is joined in its opposition to the measure by the Federal Reserve's Washington-based Board of Governors and the head of the Federal Deposit Insurance Corporation, Sheila Bair.

Meanwhile, supporters include the longest-serving policy maker in the Fed, Federal Reserve Bank of Kansas City President Thomas Hoenig, Federal Reserve Bank of Dallas President Richard Fisher, Nobel Prize-winning economist Joseph Stiglitz and House Speaker Nancy Pelosi.

Hoenig and Fisher wrote letters of support last week to Senate Agriculture Committee Chairman Blanche Lincoln, the author of the provision, referring to it as "of utmost importance to our nation's long-term financial and economic stability."

"The dynamic with two Federal Reserve presidents coming out for it publicly, and the fact that there are more who are probably going to come out for it, means that [Treasury] can't resist it any longer," the Senate aide said. "They're going to have to accept it, because [the regional Fed support] is basically undermining both Bernanke as well as Geithner."

Lincoln's proposal would compel the nation's megabanks to move their swaps-dealing units, which deal and trade in a type of financial derivative product, into a separately-capitalized institution within the larger bank holding company. The affected firms collectively would have to raise tens of billions of dollars to protect their swaps desks in case their bets go bad. Or, they could disband the activity altogether.

Along with a few foreign banks, the nation's largest domestic banks essentially control the swaps market in the U.S. By forcing them to divest their units into separate affiliates, which in turn would compel them to raise money to capitalize these affiliates, Lincoln's measure could force them to scale down their operations. At the least, supporters say, it would force them to have enough cash on hand in case their bets begin to sour, saving taxpayers from having to step in to prop up the banks like they did in 2008. That taxpayer support continues today.

In a report Monday, the Financial Times reported that former Federal Reserve Chairman Paul Volcker softened his initial opposition to Lincoln's measure, quoting him as saying: "I tend to think of the bank holding company as the relevant organization."

Of the nearly 8,000 banks in the U.S., less than 25 would be seriously affected.

"It's really a Wall Street bank issue, not a community bank issue," the Senate aide said.

Treasury spokesman Andrew Williams insisted the agency has not taken a position on Lincoln's proposal.

The measure is supported by financial reform groups and academics who wish to purge the riskiest of risky activities from the U.S. banking system. Since banks enjoy taxpayer-financed protection via federal deposit insurance and access to cheap funds from the Federal Reserve, they shouldn't use that taxpayer support to subsidize risky bets on derivatives, say proponents of the measure.

"Section 716 appropriately allows banks to hedge their own portfolios with swaps or to offer them to customers in combination with traditional banking products," Hoenig and Fisher wrote in separate letters in reference to the part of the Senate's financial reform bill that compels banks to split their swaps desks from the depository institution.

"However, it prohibits them from being a swaps broker or dealer, or conducting proprietary trading in derivatives. The risks related to these latter activities are generally inconsistent with the funding subsidy afforded institutions backed by a public safety net. Such activities should be placed in a separate entity that does not have access to government backstops. These entities should be required to place their own funds at risk," the regional Fed chiefs said.

Senate aides say that Lincoln is clarifying the legislation in order to allow for banks to appropriately hedge for interest rate risk, like when banks offer consumers fixed-rate 30-year mortgages not knowing whether interest rates are going to rise or fall over the life of the loan; to have a phase-in period of up to 24 months so banks have time to complete the transition in an orderly manner; to ensure that it's clear that bank holding companies can house these swaps-dealing units (some lawyers argue that the legislation is vague on this point); and to ensure that banks can continue to offer swaps to customers in conjunction with traditional bank products like loans.

"Banks that have been acting as banks will be able to continue doing business as they always have," Lincoln said May 5 on the Senate floor. "Community banks using swaps to hedge their interest rate risk on their loan portfolio will continue to be able to do so. Most important, we want them to do so."

In addition to Fisher and Hoenig, Lincoln cites support from the Independent Community Bankers of America, the Consumer Federation of America, AARP, labor unions and leading economists.

"I think this shows that the [Fed's] Board of Governors and Treasury are out of touch with how a lot of other people are thinking about this stuff," said the Senate aide. "We're at the end of the game here, and people are standing up and saying, 'You're not addressing the underlying problem the way you ought to be.' It's tragic."

A spokesman for FDIC chief Bair declined to comment.

House Agriculture Committee Chairman Collin C. Peterson indicated his support for the measure last week during House-Senate negotiations over combining the chambers' separate versions of financial reform legislation.

Heather Booth, head of Americans for Financial Reform, a large coalition of consumer and labor groups, said that she was told as of Monday morning that some House conferees are still pushing to substitute the lower chamber's derivatives language for Lincoln's Senate language. Using the House language as the base would be a setback to reform, said Booth, and the group is working hard to keep bank-friendly Democrats from seizing the advantage.

"It is still an issue. We are concerned where the New Dems are on that," said Booth, referring to the New Democrat Coalition, made up largely of suburban Democrats with backing from the financial services industry.

The Senate aide expressed confidence in Lincoln's measure withstanding challenges.

Reform groups are also pressing hard for a tougher version of the Volcker Rule, which would prevent banks from trading with their own money, unrelated to the benefit of their clients. The groups, along with Senate aides, insist that it and Lincoln's derivatives rules are complementary, not alternatives. Reformers are pushing for both to be included in the final bill.

A White House spokesman said of Lincoln's spin-off measure that "we continue to see this specific provision as only one small piece of the sweeping derivatives reform that Senators Dodd and Lincoln and Chairman Frank have championed. The Administration will not get ahead of the work of the conference committee as members of the House and Senate merge their respective bills. Our goal is to see a strong bill on the President's desk by July 4th."

"At the end of the day, this might end up being what people will refer to instead of Glass-Steagall, but Volcker-Lincoln," the Senate aide said.

READ Lincoln's clarification language:

SEC. 716 TERM SHEET

CLARIFICATIONS

New FED Section 13 (3) Broad Based Federal Assistance to Swap Entities would be ok

Swap Dealer can be a BHC Affiliate
-Separately capitalized
-Subject to 23A and 23B restrictions

Bank MSPs not subject to FDIC Insurance and Fed Discount window restrictions.

FDIC bridge banks, conservatorships and receiverships exempted

2 Year Transition Period to "Push Out"

FBA gets to determine time frame for push out

FBA consults with SEC/CFTC

FBA required to consider impact on:
-Mortgage lending
-Small business Lending
-Jobs
-Capital Formation

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