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Financial Reform Newsletter: Wall street's Biggest Banks Are Gambling with Derivatives and Evading Regulation Again

Wall Street’s Biggest Banks Are Gambling with Derivatives and Evading Regulation Again, Setting Us Up for Another Financial Crash
An all-star financial panel of former Federal Reserve Chair Paul Volcker, former FDIC Vice Chair Thomas Hoenig, Former Director of Trading and Markets at the CFTC (now University of Maryland Law Professor) Michael Greenberger, and moderated by Better Markets president and CEO Dennis Kelleher, assembled in New York at an event presented by Rob Johnson’s Institute for New Economic Thinking (INET) this past week to discuss new research from INET and Mr. Greenberger on how Wall Street’s largest banks continue to systematically evade regulations on derivatives and, in the process, are putting American taxpayers and the global economy at risk.

There is no disputing that unregulated derivatives gambling was the fuse that ignited the explosion that was the 2008 financial catastrophe.  They were tied to the fraudulently inflated subprime housing market that, when it collapsed, triggered payments in the trillions of dollars sending the swaps derivatives markets into a financial abyss that was ultimately filled by U.S taxpayers in the form of huge bank bailouts.  There were lots of examples, but AIG was the most visibly egregious example.

The Dodd-Frank financial reform law was enacted, in large part, to ensure that another economic meltdown triggered by unregulated derivatives never happens again.  Derivatives, particularly swaps, were to be fully regulated, transparent, collateralized, cleared and exchange traded.  To avoid a huge loophole and because the biggest Wall Street derivatives dealers all used overseas affiliates to trade their swaps (including AIG), the law also expressly covered cross-border or foreign swaps that “have a direct and significant connection with activities in, or effect on, commerce of the US.”

The CFTC was put in charge of making sure this all worked and stated in its “guidance” on cross border derivatives trading that all US swaps dealers and their “guaranteed” foreign affiliates would be subject to the Dodd Frank financial reform law.  This included 100% of the swaps dealing done by Wall Street’s biggest banks because no one would enter a complicated, high-risk, extremely expensive derivative except with a sophisticated, brand-name, credit-worthy Wall Street bank (or its guaranteed affiliate) with a huge balance sheet to structure, make markets, inventory, price and deal in such financial instruments.

However, Wall Street’s biggest banks quickly evaded this requirement by claiming a linguistic loophole that had no basis in law, markets or past practice.  As Better Markets showed in a June 19, 2014 Cross-Border Fact Sheet, each of the five biggest Wall Street banks (which accounted for more than 90% of the US derivatives markets) registered a single purportedly non-guaranteed foreign affiliate swaps dealer, claiming because it wasn’t “guaranteed” it wasn’t subject to the Dodd-Frank law.  Presto, they claimed, they were once again unregulated and non-transparent just like they were before the crash. 

As Mr. Greenberger detailed in the paper presented at the event, “Too Big to Fail U.S. Bank’ Regulatory Alchemy,” this evasion has no legitimate legal basis and is directly contrary to decades of uniform practice by Wall Street’s biggest swaps dealers.  Mr. Greenberger shows this knowing, intentional evasion of the provisions enacted to protect the American taxpayer and economy for what it was: nothing more than a “de-guarantee dodge” that Wall Street used to shift huge portions of the swaps market from U.S. banks to their newly de-guaranteed foreign affiliates. 

That would be fine if American taxpayers weren’t on the hook for the failure of these foreign affiliates, but, just like 2008, U.S. taxpayers will still be on the hook because the parent U.S. bank will ultimately inevitably cover any losses guaranteed or not to protect their reputation and a run on the bank.  This is exactly what happened in 2008, as detailed by Mr. Greenberger.  Thus, as set forth in the Fact Sheet, these are nothing more than “de facto” guaranteed affiliates and merely dropping the word “guarantee” changes nothing.  (To stop this ruse and evasion we repeatedly proposed to the CFTC that they employ a “De Facto Guarantee Test” to identify legitimately non-guaranteed foreign affiliates, which, of course, would show material market price differences between guaranteed and non-guaranteed swaps dealers.)

All of this and more, including what might be done to stop this high risk, anti-taxpayer evasion, were discussed at the INET event.  For example, the concept of “substituted compliance,” where the CFTC defers to foreign regulators rather than enforce the Dodd Frank law, was revealed as having no legal basis.  Worse, as Mr. Kelleher stated, it outsources the protection of American taxpayers to foreign regulators who have an miserable unbroken record of failure to enforce their own laws. 

Video from the event will soon be available on both the INET and Better Markets websites, which will be linked to in future newsletters.  In the meantime, read Mr. Greenberger’s paper, our Fact Sheet and, for background, our webpage collecting Better Markets’ work on cross border over the years, including our eight comment letters and a power point presentation that spells out the risks in failing to close the cross border loophole.


Stopping the Nation’s “Tailspin”
Before a crowd of more than 150 people gathered in downtown Washington, D.C., Steven Brill, author of the New York Times bestseller Tailspin: The People and Forces Behind America’s Fifty-Year Fall – and Those Fighting to Reverse It, discussed the decades of tailspin and how Wall Street, forced arbitration, lobbying and lawyers, campaign finance, due process, the First Amendment, short-termism and a host of other issues have led to the current situation.  He brilliantly illuminates how the “protected” meritocrats in the US (about 10% of the population) use “moats” to sever themselves from the “unprotected,” the 90% or so of the population that don’t have an army of lawyers, lobbyists and sundry “fixers” to build and maintain their moats.  This leaves the protected with little need for or interest in the public good or the public commons, which the unprotected depend on and which are underfunded and deteriorating, hence the tailspin.

Thankfully, Brill also highlights a number of people and organizations which are fighting to pull the country out of this nose dive, including the work Better Markets does to bring accountability to Wall Street and the country’s biggest financial institutions.  In addition to being a counterweight to them in the rulemaking and policy making processes, Better Markets also fights to get those taxpayer-backed (and recently bailed-out) financial institutions to earn their public purpose by supporting the real economy, creating jobs, wealth and prosperity for all Americans.

The evening also featured Brill leading a conversation with Better Markets president and CEO, Dennis Kelleher, as well as the heads of two other fantastic organizations featured in the book, Issue One president and CEO Nick Penniman and Open Secrets Executive Director Sheila Krumholz.  They discussed the work each organization does, how we each tell our story to galvanize support for our issues and how we all keep fighting the fight in the face of considerable opposition.  This was followed by a Q&A session where guests could pose questions to Brill, Kelleher, Penniman and Krumholz. 

While everyone has too little free time, this is a book worthy of your time.  Using historical information, in-depth reporting, insightful analysis, great storytelling and illuminating vignettes, Brill offers an unvarnished, sweeping look at what is happening in our country and the hopeful shoots showing the way back. 

You can view the discussion here, the Q&A session here and can buy the book here!


Trump’s Nomination of Permanent CFPB Director Is Nothing More Than a Shameless Ploy to Continue The Brazen Dismantling of the Nation’s Premier Consumer Protection Agency
In a move designed to attract as little attention as possible, the White House announced Saturday evening that it was nominating a staffer from the Office of Management and Budget (OMB), Kathy Kraninger, to be the permanent director of the Consumer Financial Protection Bureau (CFPB).   As Better Markets’ CEO and President was quoted in the Financial Times:

“The Trump administration continues its relentless deregulation and anti-consumer crusade with its hope-no-one-is-paying-attention Saturday night announcement.”

Lacking any regulatory, financial services or, God forbid, consumer protection experience, Kraninger has been serving as an associate OMB director, working closely with the OMB Director Mick Mulvaney, who has also been serving as the Acting CFPB Director and who has been systematically dismantling consumer protections from within the CFPB as Better Markets has chronicled.  Mr. Mulvaney’s appointment as acting Director would have ended on June 22nd if President Trump had not nominated a permanent director.  He now gets to serve for as long as it takes to get Kraninger confirmed by the Senate.

Given the circumstances, there are two likely scenarios, both of which will harm consumers.  First, Kraninger survives what is likely to be a long and difficult confirmation process to take the helm of the CFPB, but takes her cues from her old boss, Mick Mulvaney.  In the second scenario, the confirmation process drags on and on to a point where the Senate adjourns to go home for the mid-term elections, leaving Mulvaney in charge.

But regardless of which scenario comes to fruition, the one thing that sadly will not change is the damage that has been done, is currently being done, and will continue to be done to financial consumers as they are preyed upon by

  • unscrupulous payday lenders charging exorbitant interest, or
  • student loan servicers failing to process payments on time and charging fraudulent late fees, or
  • big banks pocketing hundreds of millions of dollars for bogus fees, charges and billing practices. 

Rather than consumer protection, acting Director Mulvaney has declared “open season” for financial predators on financial consumers.  He has made it clear that when he has to choose, he chooses the industry’s interests over the interests of consumers.  With Trump’s consumer protection bureau, perpetrators are comforted and victims are left on their own to fight gigantic financial institutions and their army of lawyers, lobbyists and political enablers.  There is every reason to believe that the grossly unqualified nominee will continue with the same indefensible policies. 

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