Democrats Break GOP’s Attempted Filibuster in the Senate, but Proposed Wall Street Reforms Are Pretty Flimsy

The Republican Party finally acknowledged on Wednesday that they are unwilling to alienate voters by continuing to block even debate on Wall Street reform. The good news: Democrats do not appear to have given much ground on negotiations this week as Republicans threw up their blockade. The bad news: without significant strengthening, the financial reform bill advanced by Sen. Chris Dodd (D-CT) will be too weak to end big bank abuses.

The legislation that cleared the Senate Banking Committee in March appears to have undergone two key changes amid this week’s GOP filibuster. Only one of these changes is a concession to Republicans. The other change is an unnecessary giveaway to Wall Street that Democrats have concocted on their own.

Let’s start with the self-inflicted wound. Dodd’s effort to rein in derivatives— the crazy contracts that killed AIG— wasn’t very good, but a competing bill from Sen. Blanche Lincoln (D-AR) was much better. When Democrats combined the two bills this week, they kept many of Lincoln’s strong provisions, but ditched one very important rule. Lincoln would have banned any derivatives that constitute outright gambling. Some derivatives help companies hedge risks, but others are just straightforward bets that a Las Vegas bookie could set up for you. This is the kind of trading that got Goldman Sachs into trouble with the Securities and Exchange Commission. But the SEC isn’t accusing Goldman of fraud for gambling, they’re accusing Goldman of fraud for lying and gambling, which is why Lincoln’s language would have helped.

So it’s a bummer that this provision is now gone. But it gets worse. The biggest source of trouble with derivatives is the fact that the entire market operates in secret. Banks trade with each other, and that’s the end of it. Nobody else in the market verifies the trade, and no regulator supervises it. There are two ways to deal with this, and ideally, we’d use both. First, we can simply ban abusive or risky trades (that is no longer included in the bill). Second, we can shed some light on all trades by requiring market players to sign-off on them, and let regulators watch over the trades. This would ensure that no company— let’s call it AIG—builds up trillions of dollars in risky bets that it cannot possibly make good on.

This process is called “central clearing.” If AIG can’t pay off its bet with another company, then a “central” party who “cleared” the trade will pay it off for them. That prevents a cascade of defaults that can bring down the entire economy. Central clearing alone is not enough to fix the derivatives market, but the market can’t be fixed without central clearing.

Lincoln’s bill required central clearing for almost every derivatives trade, and the Dodd-Lincoln mash-up includes that language. Unfortunately, it also includes a brief section that completely undercuts that new rule (for wonks, its Section 739, paragraphs A and B). Under the current bill, there is no penalty for anybody who fails to centrally clear their trades—even though the bill labels this activity illegal. What’s more, even though this behavior is illegal, the trade itself is still valid. In other words, banks are required to bring their trading into the open. But if they don’t shed light on their trades, nothing will happen to them. I wonder what banks will choose.

“That’s breathtaking,” says Michael Greenberger, who served as Brooksley Born’s top deputy at the Commodity Futures Trading Commission during the late 1990s. “It’s essentially telling the world that we have all of these rules, but we aren’t going to enforce them.” Born and Greenberger spearheaded an effort to regulate derivatives during the Clinton years that was thwarted by Alan Greenspan, Larry Summers and Robert Rubin.

So this week, Democrats agreed on a bill that will bring no substantive changes to the financial weapons of mass destruction that brought down AIG, without any input from Republicans whatsoever. If the bill is not fixed, Congress will not only continue to permit outright gambling in the financial system, it will allow the market to keep operating in secret.

So far, so bad. Now onto the concession to Republicans. For weeks, GOP leaders have been lying about a new “resolution fund” that Congressional Democrats want to establish. Republicans are calling it a “taxpayer bailout fund” which is totally false. When big, complex megabanks fail, President Obama and Congressional Democrats want to establish a new bankruptcy-like process for shutting them down safely. When megabanks go through bankruptcy courts, the result is an economic catastrophe, as we all witnessed when Lehman Brothers went down in September 2008.

This new process, called a “resolution mechanism” or “resolution authority,” will cost some money to implement. We have a process like this for simple, commercial banks, and it works well when the FDIC uses it. The major advantage of the resolution authority is that it allows regulators to quickly close out contracts and bets that a failed firm has engaged in. Unlike bankruptcy, the process gives investors immediate certainty about the value of those contracts and bets now that the firm is kaput. But to do this costs money, and the money has to come from somewhere.

So Dodd, at the behest of House Democrats including Rep. Brad Sherman (D-CA), decided to establish a $50 billion fund to finance this process, and to make big Wall Street banks provide the money. Making Wall Street pay for mess of a failing Wall Street bank is not a bailout, whatever Senate Minority Leader Mitch McConnell (R-KY) says.

And what’s the Republican counterproposal? Basically the same thing, except Wall Street banks will be taxed after a complex megabank fails, rather than before. This, in fact, was President Obama’s initial proposal. While Republicans were filibustering financial reform this week, the only concession that Republicans were able to wring from Dodd was an agreement to return to Obama’s original plan on the resolution authority.

Nevertheless, so far as politics are concerned, this is the kind of ingenuity that rendered progressive Democrats virtually powerless in Washington for 14 years. Republicans called this a bailout fund, and instead of showing that it is not a bailout fund, Dodd cut the provision. McConnell (R-KY) is already crowing about the “bailout loopholes” Republicans were able to close with their patriotic obstructionism.

As a matter of policy, the move is not good, but it’s not that problematic. As former Deutsche Bank Managing Director Raj Date told me:

“In one way, the question of ‘pre-funding’ the $50 billion doesn’t matter, because whether you fund it before a crisis or after, the industry is going to foot the bill. So the only relevant question is, do you want to kick big banks when they’re down — during a crisis — or when their profitability is strongly on its way back up — like over the next couple of years. If you want a stable credit system, without such big booms and busts, you should want the latter — you should want pre-funding.”

Date, who now heads the pro-reform Cambridge Winter Center for Financial Institutions Policy, is right, if the law is actually followed the next time a crisis hits. The trouble is, it probably won’t be. We can be sure that megabanks will dispatch their traditional armies of lobbyists to fight off paying into this fund. But what’s worse, the lobbyists will actually have a good argument on their side. Banks don’t have any money during a financial crisis— that’s why it’s a financial crisis. Lobbyists will say that taxing major banks after another major bank goes down would further destabilize the economy, and they’d be right.

But for better or for worse, the resolution authority debate is mostly a distraction. This fund will only matter if regulators actually invoke their resolution authority when a complex megabank is on the brink of failure. Regulators simply will not do this. First, this is a U.S. law that does not apply to international deals. Since all of the megabanks are engaged in lots of international business, there is no way that the entire operation could be shut down with only a U.S. law.

Second, even when ordinary, boring commercial banks fail, there is enormous political pressure for regulators to skirt the resolution authority and bail the firm out—if the bank is big enough. Washington Mutual, a $300 billion bank, went through the resolution process just fine. But when $700 billion Wachovia found itself on the brink of collapse, regulators arranged a merger that scored $15 billion for Wachovia shareholders. It should have been shut down. Instead, it was bailed out. When a larger and more complex megabank gets in trouble, we can expect the same thing to happen. The only way to end too big to fail is break up the megabanks into smaller companies that can fail without wrecking the U.S. economy.

So the good news is, Democrats didn’t give much ground in order to break the Republican filibuster. But the bill needs to be significantly strengthened on the Senate floor if it’s going to do any good.

Zach Carter is an economics editor at AlterNet. He writes a weekly blog on the economy for the Media Consortium and his work has appeared in the Nation, Mother Jones, the American Prospect and Salon.