Senator Blanche Lincoln’s Derivatives Reform Bill Must Pass

This is a fiery take on derivatives and too-big-to-fail institutions by Randall Wray which originally appeared at New Deal 2.0. Professor Wray believes naked shorting via derivatives should be outlawed. He goes further to say that the largest institutions are not fulfilling their public purpose in loading up on derivatives.

L. Randall Wray, Ph.D. is Professor of Economics at the University of Missouri-Kansas City, Research Director with the Center for Full Employment and Price Stability and Senior Research Scholar at The Levy Economics Institute.

Also see Mike Konczal’s take on financial reform in “6 Things Worth Fighting For in the Senate Bill.”

While most reformers are dithering around with trying to bring derivatives onto formal exchanges, Senator Blanche Lincoln (D-AR) has got the right idea: get banks like Goldman out of the business of betting against their own customers. Indeed, she rightly argues that “naked shorting” (using derivatives to bet against assets you don’t hold) is just like buying life insurance on your neighbor’s house-and then setting it afire. As we know, that is exactly what Goldman has been doing for years: marketing debt instruments to customers, and then using credit default swaps (CDSs) to bet that the debt will go bad-all the while helping to ensure that debts will go bad (through, by example, letting a hedge fund run by John Paulson’s hedge fund to pick the trashy subprimes that would go into the debt instruments sold to customers). Senator Lincoln is right: it is not sufficient to bring these practices into the light of day of formal exchanges-instead they should be prohibited practices for any financial institution that receives government support, which includes all chartered banks.

What neither Wall Street nor Washington yet understands is that all chartered banks are really public-private partnerships: they receive Treasury-supplied FDIC insurance, and they have access to the Fed as lender of last resort when things go bad. FDIC insurance makes bank deposits as good as cold, hard, government-supplied cash. Effectively, it allows banks to play with “house money“. At most, banks put up 8% of their owners’ money, and the Treasury kicks in 92% that the banks use to buy assets or to make bets. It is as if you went to Las Vegas and Uncle Sam provided 92 cents of every dollar you gambled. And if you still manage to run into trouble, Uncle Ben Bernanke stands ready to bail you out with free cash. Quite a deal! And a gamble you literally cannot lose.

Now this can be justified only if banks serve the public purpose. That is the quid-pro-quo for the sweet deal Uncle Sam and Uncle Ben provide. Banks are supposed to provide deposit services to customers, and to carefully examine credit-worthiness of borrowers. There is no other justification for bank charters. If they do not make and hold loans, and provide deposits, they have no business holding a bank charter.

It is presumed that private loan officers can do a better job at this than civil servants can do. That seems plausible, at least on the surface. But banks have gradually jettisoned that function–deciding they’d rather “originate and distribute”–originate loans but then push them onto someone else’s balance sheet. Worse, they decided that there is actually no reason to ever assess credit-worthiness since someone else will take the loss if NINJA loans go bad. Indeed, banks decided they could make even more money if they originated loans sure to go bad, packaged the very worst stuff into securities and sold these to pension funds, then used CDSs to bet the junk would crater. Jimmy Stewart thrifts they ain’t.

Goldman and other large banks serve no public purpose. The claim that they “do God’s work” is simply repugnant. Only a singularly rapacious individual who sees himself as a modern-day divinely-chosen monarch could possibly make such a statement.

To be sure we are only talking about the top ten or dozen banks-where all the derivatives are. There are literally thousands of banks all across America that still make loans, issue deposits, and have never seen a derivative. Virtually all derivatives bought or sold, held or pushed like bad heroin are the responsibility of a handful of “too big to fail” thoroughly corrupt institutions that feed at the trough of Uncles Sam and Ben. Indeed, in an ironic twist of fate, these risky and toxic institutions get the best deal of all: because they are the favorites of Uncles Sam and Ben they enjoy the lowest costs of issuing liabilities (that is to say, borrowing). Remember that 8 cents of your own money you take to Las Vegas? You pay more for that than the top gamblers-who not only get Uncle Sam to provide 92 cents of every gambled dollar, but the 8 cents of their own money put into play is cheaper for them to raise because even that is believed to be backed by our Uncles in Washington. In other words, the Washington Uncles subsidize that 8 cents, so that the biggest institutions get an unfair advantage over the thousands of institutions that reside in cities and towns all across American.

This is why firms like Goldman are said to be “backstopped” by Washington — no losses or prosecutions for fraud will be permitted. Yet hundreds and even thousands of smaller institutions will be allowed to fail during this crisis created by the likes of Goldman. They don’t get the backstop.

The recent charges against Goldman have shaken that belief, just as Senator Lincoln’s bill has Wall Street shaking in its penny loafers. Here is the choice she offers: you can continue with your derivatives, acting against the public interest, or you can be a bank. You cannot be both. Take your choice: blood-sucking vampire squid? Or, serve the public interest. If you go for squid, you lose all public protection. In that case, you go “free market” with all that entails-higher costs of borrowing, 100% downside risk, and prosecution when you lie and deceive. Go ahead and bet against your customers–they will vote with their feet if they do not like that treatment and will sue you when you screw them. Burn down houses and go to jail for arson. Your choice.

Or. Take a bank charter, and you will be protected but constrained. No activities that run against the public purpose will be permitted. Go ahead, make loans–but you will hold them on your balance sheet, and thereby take any risks associated with folly. If you make bad bets, you will wipe out the owners. Go ahead, issue deposits and your Uncles will guarantee them. But access to the public trough comes with a cost: no more derivatives, of any kind-traded, untraded, transparent or hidden-you do derivatives, you go to jail. You will face all risks-credit risk, currency risk, interest rate risk-you bear them, you cannot shift them. Depositors will not lose if you make bad loans–but your owners and management will. Owners will lose their capital; managers will lose their jobs and face real time in prison should they betray the public trust by trying to shift risk or by betting on another’s misfortunes.

That is real reform, and anything less should be rejected by Washington. Forget the hogwash about losing the derivatives business to the UK, Euroland, or offshore paradises. Goodbye and good riddance. Derivatives have nothing to do with provision of loans and deposits in the public interest. They are the equivalent of “shooting galleries” where illicit pushers sell drugs to addicts. Nay, they are worse-they are the undertakers that vie for the burial business, and spike the drugs with lethal concoctions.