Federalism in the Derivatives Market

Financial regulatory reform at the federal level is bogged down in a lobbying scrum. The Senate Finance Committee just voted along party lines to send Senator Christopher Dodd's bill to the Senate floor. But the outcome and timing there remains in unclear. All we know is that something might happen sometime. The subject with the least certainty of reform is the derivatives market.

The derivatives market was the scene of the crime for the 2007-08 financial crisis. Stupid, bad and fraudulent mortgage lending practices at the consumer level were greatly magnified by the profits and compensation that could be and were obtained from securitization and the creation of CDOs, CMOs, and so on. Derivatives seemed to magically transfer risk out of sight (and therefore out of mind), while generating Brobdingnagian earnings for Wall Street. Bad loans were transformed into "good" investments, and a lot of very smart financiers somehow concluded that if bad loans could thusly made good, then they should make many, many more bad loans in order to do more "good."

The sheer weight of all those bad loans--trillions of dollars worth--are a crucial reason why the economy remains stagnant. The housing market won't recover for years because of the overhang from foreclosures and homes with defaulted mortgages awaiting foreclosures. Much of today's long term unemployment is attributable to people, mostly men, who were formerly employed in homebuilding and now have nowhere to go. The derivatives markets have done great damage to the economy.

Moreover, it appears that many American municipalities bought derivatives products that turned out to be losers, costing them taxpayer money rather than saving it. The idea apparently was that certain derivatives, like interest rate swaps, could provide cities with a lower net cost of borrowing. But interest rates, pushed down by the Fed, have imposed costs on these cities rather than saving them money. Municipal services are being cut in order to make payments to big banks.

Some states may limit the ability of municipalities to purchase financial derivatives. The risks are seen as incomprehensible and therefore too large. (If you don't understand an investment risk, it's too large for you because you don't know how bad things can get.) Limiting municipal investments isn't new. Many municipalities can invest bond offerings only in extremely low risk investments; no junk bonds or penny stocks. There's nothing intrinsically wrong with taking derivatives off the table. It looks like some states won't wait for federal reforms. They'll change the derivatives markets their own way.

Meanwhile, across the pond, the EU is giving increasingly serious consideration to limiting trading in credit default swaps. Furthermore, the uproar over the use of derivatives to sweep sovereign debt under the carpet is likely to shrink the market for such maneuvers.

Wall Street's lobbying power is unsurpassed, and meaningful federal action to improve the regulation of derivatives cannot be predicted. But that doesn't mean everyone else will take their losses lying down. State governments may feel impelled to act. The EU clearly intends to act. The derivatives markets may be balkanized with a different set of rules every few hundred miles. The Street may get what it wished for--and then be sorry.

Of course, the big banks that are the principal dealers in the derivatives markets could revive an old, discarded Wall Street tradition and offer derivatives in ways that place the interests of customers first. But that would be so 20th Century.