Wall Street’s true ambitions are often revealed in mind-numbing minutiae.
The latest example is Citigroup’s participation in writing a House of Representatives bill that intends to roll back an arcane part of the Dodd-Frank financial sector overhaul. As The New York Times reported on Friday, Citigroup’s recommendations were reflected in more than 70 lines of the House committee’s 85-line bill.
The bank’s involvement was something of a surprise. Since the financial crisis of 2008, Citigroup has not been a vocal critic of efforts to make the financial system stronger. It supported parts of the overhaul. Citigroup’s reluctance to publicly press for changes may also be down to the fact that it received more bailout money than other banks, and performed poorly for a long time after the crisis.
So what stirred Citigroup to get deeply involved in crafting the House bill? Perhaps it was heightened fears about its bottom line.
The proposed legislation attempts to soften a part of Dodd-Frank Act that focuses on the market for derivatives, which are financial instruments that allow financial firms to hedge their risks or speculate. Banks make a lot of money from these instruments, entering into trades with other banks, investment funds and corporations. Even the most commonly traded derivatives, like interest-rate swaps, have much higher profitability than other Wall Street activities, according to bank disclosures.
But the financial crisis revealed the enormous risks lurking in the derivatives market. It was opaque, which stokes panic in turbulent periods.
And derivatives allowed financial firms to make big bets without having to put up sufficient money at the outset. The most chilling example of this was American International Group, which placed staggering wagers on mortgages that it ultimately could not honor without taxpayer help. Dodd-Frank does a lot to remove such weaknesses.
But the law also attempts to reduce a big perk that the derivatives market has enjoyed for years, and will for the foreseeable future.
Most banks locate essentially all their derivatives inside subsidiaries that enjoy indirect taxpayer backing, either through deposit insurance or access to emergency lending from the Federal Reserve. The banks’ trading partners like this arrangement because get to deal with taxpayer-backed entities.
If the clients had to do the same derivatives trade with a bank subsidiary that didn’t have government support, they might ask for much better terms, reducing the profits for the bank. The perceived problem with this set up is that a whole range of derivatives activities, some of it speculative and risky, is effectively subsidized.
Some writers of Dodd-Frank found this troubling and wanted certain types of derivatives to be “pushed out†of bank entities that enjoy government backing. But even back then there was strong opposition to such a move.
The result was a pallid push out. When Dodd-Frank became law, only a few types of derivatives had to be moved out of insured subsidiaries. All existing derivatives, no matter what they are, get to stay inside the safety net. And regulators have effectively told banks they don’t have to comply with the push out till the middle of 2015.
Even so, Dodd-Frank was reviled on Wall Street, and the new House bill would almost completely neuter it.
The bill would allow the few types of derivatives that are slated for push-out to remain inside taxpayer-supported entities. For instance, derivatives for betting on stocks and commodities would get to remain in the safety net.
The one derivative that the House bill does push out are swaps on securities that are backed with a basket of assets, like mortgages, but even these would be allowed inside taxpayer protected entities if they met certain conditions.
Those favoring the House bill make arguments that will resonate with regulators.
The push out rule, they say, could shift derivatives trading into unregulated entities. It could also make it harder for the Federal Reserve to support the financial system during a crisis, since it couldn’t lend to entities that deal in the pushed-out swaps.
Such arguments are blunted by the fact that Dodd-Frank pushes out only a few types of derivatives.
But it is those few types of derivatives may be among the most profitable for banks.
Take credit default swaps, which allow financial firms to bet on the creditworthiness of companies, countries and mortgages. The House bill significantly softens the treatment of such derivatives. Under Dodd-Frank, a bank would have to push out credit default swaps that don’t trade through a clearinghouse, an entity set up to make sure market participants have the money to back their trades. The new bill effectively allows these “uncleared†swaps to stay inside government insured banks.
These swaps likely have attractive margins which would be depleted if they were pushed out. Uncleared instruments are a big part of the credit default swap market. Only about 10 percent of such swaps are centrally cleared, according to official surveys.
Citigroup has a huge presence in this market. With some $3 trillion of exposure, the bank is one of biggest default swap dealers in the United States. Those swaps right now live inside an entity called Citibank N.A. that enjoys federal deposit insurance. Nearly $2 trillion of those swaps are based on companies or other entities with a junk credit rating.
As it stands, the Dodd-Frank Act would push many of those swaps out.
Perhaps that’s why a Citigroup employee is writing legislation that would stop just that.
