Derivatives: Major Player In Economic Troubles

A Senate panel on Wednesday plans to take up a measure imposing regulations on over-the-counter derivatives — the privately traded financial contracts that businesses use to hedge their bets on the value of a commodity or investment. The measure would effectively require Wall Street banks to spin off their derivatives trading desks. Republicans say it's overkill, and could drive the derivatives market overseas.



Its MORNING EDITION from NPR News. I'm Steve Inskeep.

We're tracking two government efforts to keep up with the complexities of modern finance. Anybody who wonders how those efforts matter need look no farther than their pension fund statements from 2008. The government wants to stop practices sometimes blamed for the financial crisis.

In a moment, we'll report on the regulators who went after Goldman Sachs. We begin in the Senate, where lawmakers want to rewrite some rules. They're focusing on financial tools called derivatives, which in theory businesses would use to lower risk.

Today, a Senate panel considers how to regulate a multi-trillion dollar industry.

Here's NPR's Audie Cornish.

AUDIE CORNISH: So what exactly is a derivative?

Professor LYNN STOUT (UCLA School of Law): A derivative is nothing more than a bet on what's going to happen in the future. So for example, an interest rate swap is a bet that interest rates are going to rise or fall. If the interest rate goes up, one party simply pays off the bet to the other party.

CORNISH: This is Lynn Stout. She's a professor of corporate law at UCLA. Stout says, for example, the insurance company AIG sold a lot of a certain kind of derivative related to mortgage-backed securities that eventually went bad. By the time the government got involved in the financial crisis, it wasnt easy to untangle how much AIG owed and to whom.

Stout sees the situation this way...

Prof. STOUT: The problem is, after the year 2000, Congress legalized anybody who wanted to to buy and sell derivatives on bonds without requiring they actually own it. It's a basically a lot like letting people buy fire insurance on other people's houses. It means that a lot of people are betting on something and taking on risk that they weren't taking on before and it also creates an incentive to burn down a few of the houses.

CORNISH: Lawmakers are trying to avoid a repeat of that scenario. Since the derivative market originally grew out of the world of farm commodities, the Agriculture Committee is writing the provisions, which are expected to be included in the financial regulatory bill.

Iowa Democrat Tom Harkin is on the panel.

Senator TOM HARKIN (Democrat, Iowa): Let's put these things out there transparently so everyone knows whos doing what and what's being traded and how much is being traded and what the value of these derivatives are and what they're based on.

CORNISH: Senator Blanche Lincoln, who chairs the committee, is proposing that most of these deals been done on an exchange similar to those for stocks and bonds. Swaps would have to be reported to regulators and go through a clearing house to make sure all parties have enough money to cover their deals. Some groups, like farmers, airlines and manufacturers, would be able to get exemptions from the exchange and could continue to use derivatives to defend themselves against price swings and commodities.

But Lincoln's bill would go beyond both the House and the Obama administration's proposals by requiring banks spin off their derivative business or loss their FDIC insurance and access to Federal Reserve credit.

Senator BLANCHE LINCOLN (Democrat, Arkansas): Banks will need to decide. It'll be up to them to decide whether they want to be banks or if they want to engage in the risky trading that caused the collapse of firms such as AIG.

CORNISH: And this is where the proposal goes especially wrong, according to Republicans. New Hampshire Senator Judd Gregg...

Senator JUDD GREGG (Republican, New Hampshire): If we come forward with an overly regressive approach here, an over bureaucratic approach, one which basically responds to a hyperbole of the moment, which is that all derivatives are bad and not transparent and therefore must be put on exchanges, something like that, we're basically going to push offshore the vast amount of derivative activity. It is critical to our industry and America being competitive.

CORNISH: Financial firms, which make billions of dollars on derivatives, are fighting the proposal.

Scott Talbott is from the Financial Services Roundtable.

Mr. SCOTT TALBOTT (Financial Services Roundtable): If a financial institution doesnt take as much risk, that may sound appealing at first blush, but if you think it through, it means fewer loans, fewer credit card loans, less activity, which is not a good thing for the economy as well as for individual borrowers and for businesses.

CORNISH: This is by no means the last word on derivatives legislation. Senator Gregg says he's still working on a competing effort for a bipartisan proposal from the Banking Committee. But for now, the Agriculture Committee bill is the only proposal on the table.

Audie Cornish, NPR News, the Capitol.






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