Dodd Bill Sets Up America for Another Credit Default Crisis

05/28/2010 05:12 am ET | Updated May 25, 2011

As details of Senator Dodd's financial reform bill began to emerge, it became clear that the complex financial engineerings of Wall Street have migrated to Washington. The Dodd bill to prevent future collapses in the financial markets basically creates a federal version of the complex and toxic credit default swap, which helped get us into the original mess.

A credit default swap is basically an insurance policy that guarantees that the purchaser of the policy is paid out in full in the case of a financial default. In this case, the financial services industry is the purchaser and the US taxpayers are the providers. US taxpayers will be asked to insure the future failures of our largest financial companies and those companies will provide a $50 billion bailout fund. For this unlimited guarantee of financial solvency, the big money firms are only being asked to fund less than 5% of the amount used in the current bailout and participate in the appropriate oversight boards and regulations. And this, my fellow taxpayers, is a hell of deal. But not for you and me.

The financial industry has made a history of using campaign donations to prevent the addition of even the most innocuous regulation. In the past 10 years, they have spent over $2.5 billion on these efforts and are undoubtedly gearing up to spend even more. As always, they will argue that any additional regulation reduces their competitiveness worldwide and increases the cost of credit and capital to American consumers and corporations. What they fail to mention is that without the insurance policy provided to them by the same government they complain restricts them, they would have failed multiple times in the past hundred years.

The benefits of this type of policy have already been demonstrated for the industry over the past 18 months. That trillion we spent on the recent bailout was simply used to stabilize the industry and there were promises of even more money if needed. The crisis we are still managing has made explicit what the US government guarantees and what it does not. There used to be implicit guarantees around Fannie Mae and Freddie Mac but those were certainly made explicit by the fact that the near collapse occurred and the government came to the rescue, adding hundreds of billions to an already swelling federal deficit.

Government guarantees have an incredible amount of value to these businesses. Being able to borrow cheaply from the Federal Reserve reduces their cost of capital. Having access to inexpensive FDIC insurance allows them to pay lower interest rates on customer balances. Government guarantees on their bonds further reduces the interest rates they must pay on their debt.

Historically, all of these guarantees have been provided essentially for free to the financial industry. FDIC insurance was supposed to be paid for by the industry, but as of late 2009, the fund was over $20 billion in the red. The only reason that number is not closer to $1 trillion is that the US Government bailed out the largest of the banks, preventing their failures from making the FDIC fund look like a finger in a large dike. This negative balance is, of course, again being covered by the US tax payers.

If the Dodd bill proposes nothing else, it ought to offer more protections against excessive leverage and greater strength in the protective funds. None of the benefits provided to our financial institutions by the government are inexpensive and each one offers a competitive advantage in the industry; especially against foreign companies. This is worth a great deal to financial services companies that are being protected by American taxpayers. Essentially, we are talking about a government credit default swap in the Dodd bill. And in a capitalistic economy, it only makes sense that the provider of the insurance would expect a form of payment for guaranteeing the risk; the risk takers also ought to expect they are subject to additional oversights to reduce the odds of another catastrophic default.

The financial services industry may not like this deal. But this is a free market, (at least in theory), so I would encourage them to shop around and see if they can get a better offer. Chances are good they won't find another entity interested in providing over a trillion dollars of coverage for an indefinite amount of time for a modest upfront payment of $50 billion, and a little regulatory oversight. But if they can find a better deal, they ought to take it. Taxpayers aren't going to lose any sleep over losing this contract.