Passing laws is all about compromise.
Even you are not an elected lawmaker, you know the drill. “You scratch my back, and I will back your horse.”
More often than not, between the back scratching and horse trading, the original intent of a bill gets lost in the political scuffle. That’s exactly what’s happening to the financial overhaul bill that Senate Majority Leader Harry Reid vows to bring back on Wednesday.
After you get through all the grandstanding and peel back the rhetoric, the question is whether the new law will do what it’s supposed to do. Namely, prevent another financial meltdown of the sort from which we are now just emerging.
The answer is no, especially, if Congress and the President accept the deal being pushed by Warren Buffet and his pals on Wall Street.
Warren Buffet is an American icon. He’s known as the “Oracle of Omaha.” In addition to his undisputed success as America’s leading investor, Buffet is usually a principled beacon in a foaming sea of dubious business morality.
This time, however, Buffet is transparent. He’s acting only is his own best interest, not on behalf of the little guy as he so often appears to do.
Behind the scenes, Buffet has been furiously lobbying for an amendment that would largely exempt existing derivative contracts from the new rules. Buffet fears that the new legislation will force companies like his Omaha-based Berkshire Hathaway to set aside large reserves to cover potential losses. Berkshire’s current derivative portfolio is about $63 billion.
Buffet’s insistence on a provision to “grandfather” existing contracts away from the bill’s purview is remarkable because he has repeatedly warned of the potential dangers associated with derivatives, famously labeling them as “weapons of mass destruction.”
Understanding Derivatives
Derivatives contracts are bets between two parties on the future price of a good, such as oil or mortgages. Typically, derivatives are used by companies to manage risks. Airlines employ derivatives to lock in future fuel prices. Farmers use them to protect or hedge the future value of their crops.
Over the past ten years, derivatives have moved from a sideline business to become a central part of Wall Street profits. Through the use of derivatives, banks can boost their leverage on everything from currency futures to mortgage bonds. Banks hedge their exposure with derivative devices such as credit default swaps, a type of insurance instrument to cover their potential losses.
Derivatives also represent an estimated $500 trillion market used across Wall Street to hedge, insure and bet on the future prices of those underlying assets. Last year, fees on derivative contracts accounted for $20 billion in revenue on Wall Street.
Insurance giant AIG was nearly toppled by trading derivative securities related to mortgages. The American taxpayers prevented the insurer’s complete collapse by bailing it out to the tune of $182 billion. Even though it was an insurance company, AIG did not have and was not required to maintain sufficient reserves to cover the losses stemming from its derivative exposure.
Any serious discussion about “too big to fail” must start and end with reforming and regulating the derivatives market.
Buffet’s Machinations
Buffet vehemently opposes that aspect of the legislation that would compel banks and other federally insured financial institutions to either spin off their derivative businesses, creating separate hedge funds, or set aside enough in capital reserves to cover their exposure. This would mean that companies like Buffet’s Berkshire, that has extensive banking interests, would have to commit substantial chunks of cash to reserves instead of putting those funds into otherwise profit-making investments.
The proposed legislative reform would also require that all derivatives be traded on regulated exchanges similar to stocks or bonds. Unlike futures contracts, such as corn or pork bellies that are traded on regulated exchanges, most, derivatives at the core of this crisis were transacted in private deals not subject to oversight or regulatory scrutiny.
Combined with the Clinton-era repeal of the Glass-Steagall Act — the post-Depression provision that built a firewall between investment and commercial banks — unregulated derivatives stand as the greatest single threat to the continued stability of our financial system.
Derivatives in and of themselves are not destructive. Financial derivatives, however, of the sort that forced the failure of otherwise rock solid concerns like Lehman Brothers need to be brought out of the shadows. Federal regulated banks and financial companies that use them should be compelled to account for their risks by putting up adequate reserves to avert the need for future bailouts. Like many Americans, when Warren Buffet talks, I listen. Despite the political cost — Buffet normally aligns himself with the Democrats — both the Congress and White House need to ignore Buffet’s folksy charm and Machiavellian machinations.
This time, too much is at stake.
John Cohn is a senior partner in the Globe West Financial Group based in West Los Angeles. He may be contacted at www.globewestfinancial.com
