AR-Sen: Lincoln's Proposed Reforms Seriously Flawed

With just one week to go until the May 18, 2010 preferential primary, I think it’s fair to say that the Bailout Blanche Experience versus Dollar Bill and The Outsourcers has been a conflict not seen since Wyld Stallyns bested (uncredited) Primus in the Fourth Annual San Dimas Battle of the Bands.1
As we enter the homestretch and the polling gap continues to narrow, the wild card in the whole thing seems to be the success (or lack thereof) of Lincoln’s proposed derivative reform legislation.  Theoretically, there could be a vote on the measure this week.  Yet, for whatever reason — I suspect a lack of background in economic theory on the part of writers and readers — it seems to be a commonly accepted “fact” that the proposed legislation is a good idea, both in conception and execution.  Blake Rutherford suggested as much not too long ago, noting:

Still, the bill itself is quite a good one.  In an election year, I can’t expect Mr. Halter to praise the bill – Ms. Lincoln’s signature piece of legislation since becoming chairperson of the Senate Agriculture Committee. But it is unreasonable to suggest that he stop rooting for the bill to fail?
In the past he has has said that he supports “the the strongest possible financial reform bringing more accountability to our financial markets so that another financial meltdown doesn’t happen.” If that’s true, shouldn’t he be encouraging the Lincoln measure – which would bring meaningful and needed reform to derivatives markets – to stay in the bill?

Blake discussed this in the context of how many organizations, including pro-Halter groups like the AFL-CIO, support Lincoln’s proposals.2 Indeed, it seems that the conventional wisdom is that, for all Lincoln’s faults, this bill is proof that she can be an effective Senator.  Now, far be it from me to argue with conventional wisdom, but…

I’m gonna have to go ahead and disagree with you there, Bob.
Full disclosure: When I first read that Lincoln had proposed a tougher bill than was expected, I commended her.  Then I read the proposed measures, and the old econ geek in me was more than a little underwhelmed.  You see, from a macroeconomic standpoint, there is a strong argument to be made that some of Lincoln’s proposed reforms will not only be ineffectual, but (at least) one provision could very well be disastrous.
The biggest flaw in the bill is Section 106, which prohibits any “Federal assistance,” including Fed lending, to any financial institution that trades derivatives, including clearinghouses.  Curiously, however, Lincoln’s bill also mandates extensive clearing and thereby makes clearinghouses an integral part of the financial system.  (I want us all to be on the same page, so for an explanation of what derivatives and clearinghouses are, check the footnote to this sentence.3)
It seems that Ms. Lincoln is so hell-bent on shedding the “Bailout Blanche” sobriquet that she is willing to say “Ok, that’s it, no one gets any money at all.” While it might play well to the general population right now, this is a horribly short-sighted move. You see, Lincoln and others have apparently conflated the concept of a bailout, wherein taxpayer monies are transferred to the claimants of an insolvent firm, with the exercise of the Fed’s lender-of-last-resort (LOLR) functions, wherein the Fed provides liquidity in times of crisis by lending against good collateral4.
Lincoln’s bill is apparently premised on the idea that, by forcing these derivatives into clearinghouses, the market for them will somehow become more liquid and more transparent.  This is absolutely backward; clearinghouses need liquidity and transparency in order to work, but they do not create these things.  By misconstruing the genesis and importance of liquidity in cleared markets, Lincoln’s bill also manages to ignore the lessons of the not-so-distant past.  As we saw during the crash of 1987, during periods of market stress, the demand for liquidity skyrockets as firms have to respond to big price moves.  These initial big price moves actually create something of a self-fulfilling prophecy — the large market move creates correspondingly large margin/collateral calls, which leads to people liquidating to meet these calls, which moves the price further, and so on.  And, if you will recall, it was the Fed supplying massive amounts of liquidity through banks (and “encouraging” those banks to lend that money) in 1987 that prevented a complete implosion of clearinghouses.
A second, related problem with Section 106 is that it, in effect, prevents banks from engaging in any derivative transactions either as an intermediary or to hedge the bank’s own risk.  The purpose of this, as best I can tell, is to separate derivatives trading completely from the financial system as a whole, ostensibly to remove the risks associated with derivatives trading from financial system. This is literally impossible; derivatives trading is inextricably linked to banking and other financial institutions. Nor will the expanded mandated clearing change this; clearing does not remove the interconnectivity of institutions, but merely shifts some of the connections (and, in certain cases, adds more connections).
So, taken together, Section 106 attempts to do what literally cannot be done (separate derivatives from the rest of the financial system) and then cuts off an integrally important part of the system from the emergency LOLR functions of the Fed. The section does nothing to reduce the risk of the system needing access to emergency liquidity, but it makes providing that liquidity next to impossible.  See the problem here?
Section 106 may be the worst part of the bill, but it definitely not the only flaw. For example, Section 120 oddly imposes a fiduciary duty on dealers who enter into a swap with a retirement fund, pension fund, endowment, or any governmental entity.  Apparently, no one has considered that ERISA already imposes a fiduciary duty on the managers of those funds/endowments/entities.  Lincoln’s bill attempts to impose on the swaps dealer a fiduciary duty to both sides (not possible) rather than tightening the enforcement of existing fiduciary duties under ERISA for managers who are already transacting at arm’s length with the dealers.
I am at a loss as to what Section 120 would accomplish, actually.  Unlike Section 106, Section 120 is not the kind of glaring mistake that could potentially exacerbate a financial meltdown, but it is an extra layer of protection and confusion where none is needed.
Is this bill all bad?  No, of course not.  Do we need some financial reform and regulation?  Yes.  What we don’t need, however, is a bill with a flaw as big as Section 106 being rushed through for political posturing.  Since Lincoln is taking the “damn the torpedoes” approach so that she can talk about her tough reforms in television commercials, I can only hope that someone else takes a step back and considers the long-term implications of this bill.  If not — if we are saddled with Section 106 — the next crisis will come, and it will be much, much worse.4

1 And, with that, I can check “be the first political blogger to reference ‘Bill & Ted’s Bogus Journey’ in a post about a Senatorial race” off my bucket list.  Sweet.
2 I chalk this wide support up to a similar lack of understanding about economic theory, clearinghouses, etc.
3 What are derivatives? Simply put, a derivative is an agreement between two parties that has its value determined by the price of an asset. This asset is called the “underlying.” Derivatives are commonly classified by how they are traded or by the relationship between the agreement and the asset. In the former, derivatives are classified either as over-the-counter (OTC), where the parties privately agree on how their trade will be settled in the future, or exchanged-traded derivatives (ETD), where parties trade standardized contracts through an intermediary exchange.
The latter classification differentiates between options, giving the right to purchase/sell the underlying in the future at a pre-determined price; futures, creating the obligation to purchase/sell the underlying at a pre-determined price; and swaps, creating an agreement between parties to exchange the benefits of their respective financial instruments.
Like many financial instruments, derivatives serve two broad purposes: hedging against risk by passing some of the risk to another party and speculative investing in the form of betting on which way the value of the underlying will move.
What is a clearinghouse? A clearinghouse is nothing more than an intermediary financial institution that provides settlement services and mitigates risk by, among other things, requiring that parties post collateral every day to cover the possibility of a default.
4 Besides, if Lincoln wants to impose protections that actually matter, maybe she should at least address Fannie Mae and Freddie Mac. Neither her bill, nor the Dodd bill, do so.