On few political issues has the ground shifted so much in recent years as on derivatives regulation. Typically the exclusive province of specialists, these securities have emerged as central to the Obama administration's push to move a financial regulatory bill through Congress.
The Senate may begin debate on such a bill next week. President Obama threatened last week to veto any bill that does not regulate derivatives.
In his speech calling for tighter financial regulation Thursday in New York, Obama noted that derivatives have been called "financial weapons of mass destruction ... that were bought and sold with little oversight."
Obama's insistence on addressing derivatives — and the sense shared by lobbyists on all sides of the issue that derivatives will inevitably fall under greater scrutiny of some kind — represents a remarkable turnaround.
A dozen years ago, President Bill Clinton, Federal Reserve Chairman Alan Greenspan and Congress all opposed government oversight of derivatives. A law enacted in 2000 made it clear that most derivatives could not be regulated. Derivatives serve a legitimate purpose in hedging risks and there was concern at the time that imposing too much regulation would put the U.S. out of line in what is truly a globalized market.
Some of those worries remain valid. Still, the former consensus against regulation has flipped around almost entirely. Derivatives are widely viewed as a key contributor to the near-collapse of the financial markets in 2008. It's clear that any financial overhaul bill that clears Congress this year will impose new restrictions on derivatives trading.
So just what are derivatives?
Taking Out Contracts
Basically, derivatives are side bets about prices going up or down. As their name suggests, derivatives are contracts with a value that is derived from something else. They can be based on tangible commodities such as wheat, oil or corn, or on financial instruments such as interest rates, common stock or currency valuations.
Some are relatively straightforward. Many companies use derivatives to hedge against price changes that affect their profit margins but aren't at the core of their operations. For instance, an airline company might enter into derivatives contracts based on home heating oil prices. That way, if the price of oil shoots up, the company makes money on the derivative that offsets the increase in its fuel costs.
But not all derivatives are so simple. It's one thing to enter into contracts that are based on fixed guideposts, such as an agreement to buy fuel oil at a certain price on a certain date. Plenty of derivatives, however, are customized, tied to the needs of one particular company or individual.
A manufacturer, for example, might enter into a contract that protects it against local currency fluctuation that is tailored to the exact value of a product it is exporting on the exact day that product is scheduled to arrive in another country.
Confused yet? It gets a lot more complicated in a hurry. The fact that eyes glaze over even within financial firms is one reason that Obama cites for the derivatives market's getting out of hand. "Many practices were so opaque, so confusing, so complex that the people inside the firms didn't understand them, much less those who were charged with overseeing them," he said Thursday.
What If It All Goes Wrong At Once?
But complexity isn't the biggest problem. The real issue is that derivatives can have a compounding effect.
In the late 1990s, financial firms led by J.P. Morgan & Co. pioneered a new form of derivatives called credit default swaps, which offer insurance against default on loan payments. The party seeking protection against default will pay a fee to another entity that will swallow the loss if the underlying bond, mortgage or bank loan isn't repaid. The guarantor is betting that the fee it receives will be larger than any losses it might incur.
But what if millions of loans go bad all around the same time? That's what happened in the fall of 2008, as foreclosures mounted around the country. The result was billions of dollars in losses — and a massive government bailout — for American International Group, which was a huge player in credit default swaps.
"You are not going to get the public engaged on the details of the debate about what derivatives policy should look like," says Barbara Roper, director of investor protection for the Consumer Federation of America. "But if you go to the public and say that Congress failed to address the key problem that led to the bailout of AIG, that's a different matter."
Risky, Profitable Business
That's why derivatives regulation, as complicated as it is, throughout the congressional debate has seemed more certain to end up in any final bill than other proposals with seemingly greater popular appeal, such as the proposed creation of a consumer protection agency.
But there's still been plenty of argument about what derivatives regulation should look like. Major banks are opposed to moving derivatives trading onto an exchange, arguing that many derivatives have to be customized or otherwise are not suited to exchange trading. Their critics argue that banks simply fear the price transparency that exchange trading would force because it would eat into their profits.
One widely cited estimate is that a handful of major banks took in $35 billion last year by acting as matchmakers between parties to derivatives contracts. Those profits are directly threatened by legislation approved by one Senate committee.
Bills approved by both the Senate Banking and Agriculture committees would require most derivatives to pass through a regulated clearinghouse. But the Agriculture bill goes further.
The committee's legislation, approved Wednesday, would also force big banks to get out of the derivatives trading business. "If banks want to be banks ... they need to spin off risky activities," said Blanche Lincoln (D-AR), who chairs the committee. "There's no reason why taxpayers or our community banks should be bearing the risks of insuring that risky business."
Lincoln's proposal to kick banks out of this particular casino is unlikely to survive. It's opposed not only by Senate Republicans but by the Obama administration.
Concentration Of Risk?
Other than that, says Phillip Swagel, a former Treasury Department official under President George W. Bush who now teaches at Georgetown University, there's broad bipartisan agreement about the need to create more transparency in the derivatives market.
But moving most trades to a clearinghouse won't be a panacea, he says. Exchanges or clearinghouses will be able to impose collateral requirements. But they'll have to gain expertise as they go in terms of how much leverage they're willing to allow. Otherwise, they could end up making the same type of mistakes about calculating risk that got AIG into trouble.
"Clearinghouses and exchanges don't take away all the risk. In a sense, they concentrate all the risk," Swagel says. "It's not like you do this, and we never worry about derivatives again."