As the financial crisis entered one of its darkest phases in October, a handful of the nation's largest banks began holding daily telephone sessions. Murmurs were already emanating from Washington about the need for a wide-ranging regulatory overhaul, and Wall Street executives girded for a fight.
Atop the agenda during their calls: how to counter an expected attempt to rein in credit-default swaps and other derivatives - the sophisticated and profitable financial instruments that were intended to limit risk but instead had helped take the economy to the brink of disaster.
The nine biggest participants in the derivatives market - including JPMorgan Chase, Goldman Sachs, Citigroup and Bank of America - created a lobbying organization, the CDS Dealers Consortium, on Nov. 13, a month after five of its members accepted federal bailout money.
To oversee the consortium's push, lobbying records show, the banks hired a longtime Washington power broker who previously helped fend off derivatives regulation: Edward J. Rosen, a partner at the law firm Cleary Gottlieb Steen & Hamilton. A confidential memo Mr. Rosen drafted and shared with the Treasury Department and leaders on Capitol Hill has, politicians and market participants say, played a pivotal role in shaping the debate over derivatives regulation.
Today, just as the bankers anticipated, a battle over derivatives has been joined, in what promises to be a replay of a confrontation in Washington that Wall Street won a decade ago. Since then, derivatives trading has become one of the most profitable businesses for the nation's big banks.
The looming fight over regulation is the beginning of a broader debate over the future of the financial industry. At the center of the argument: What is the right amount of regulation?
Those who favor more regulation say it would offer early warning signals when companies take on too much risk and would help avert catastrophic surprises like the huge derivatives losses at the giant insurer the American International Group, which has so far received more than $170 billion in taxpayer commitments. The banks say too much regulation will stifle financial innovation and economic growth.
The debate about where derivatives will trade speaks to core concerns about the products: transparency and disclosure.
There are two distinct camps in this argument. One camp, which includes legislative leaders, is pushing for trading on an open exchange - much like stocks - where value and structure are visible and easily determined. Another camp, led by the banks, prefers that some of the products be traded in privately managed clearinghouses, with less disclosure.
The Obama administration agrees that more regulation is needed. A proposal unveiled recently by Treasury Secretary Timothy F. Geithner won plaudits for trying to make derivatives trading less freewheeling and more accountable - a plan that hinges in part on using clearinghouses for the trades.
Critics in both the financial world and Congress say relying on clearinghouses would be problematic. They also say Mr. Geithner's plan contains a major loophole, because little disclosure would be required for more complicated derivatives, like the type of customized, credit-default swaps that helped bring down A.I.G. A.I.G. sold insurance related to mortgage securities, essentially making a big bet that those mortgages would not default.
Mr. Rosen and other bank lobbyists have pushed on Capitol Hill to keep so-called customized swaps from being traded more openly. These are contracts written for the specific needs of a customer, whose one-of-a-kind nature makes them very hard to value or trade. Mr. Rosen has also argued that dealers should be able to trade through venues closely affiliated with banks rather than through more independent platforms like exchanges.
Mr. Rosen's confidential memo, dated Feb. 10 and obtained by The New York Times, recommended that the biggest participants in the derivatives market should continue to be overseen by the Federal Reserve Board. Critics say the Fed has been an overly friendly regulator, which is why big banks favor it.
Mr. Rosen's proposal for change was similar to the Treasury Department's recently announced plan to increase oversight. Treasury officials say that their proposal was arrived at independently and that they sought input from dozens of sources.
Even so, market participants, analysts and members of Congress who have proposed stricter reforms worry that the Treasury proposal does not go far enough to close several important regulatory gaps that allowed derivatives to play such a destructive role in the current financial crisis.
But increased transparency of derivatives trades would cut into banks' profits - hence the banks' opposition. Customers who trade derivatives would pay less if they knew what the prevailing market prices were.
"The banks want to go back to business as usual - and then some. And they have a lot of audacity now that everyone has bailed them out," said Yra Harris, an independent commodities trader who was involved in an effort to regulate derivatives nine years ago. "But we have to begin with the premise that Wall Street doesn't want transparency, because more transparency means less immediate profits."
Legislators in the Senate and the House of Representatives have introduced bills offering stricter controls than those pushed a decade ago. The pending legislation goes even further than Mr. Geithner's proposals.
"These mathematical geniuses who create these things can find a way to turn anything into a customized swap," said Senator Tom Harkin, an Iowa Democrat, who has introduced legislation that would require all derivatives to be traded on an exchange. "You'd get a loophole big enough to drive a truck through. It could be worth trillions and trillions of swaps."
Lessons From History
Hotly contested legislative wars are traditional fare in Washington, of course, and bills are often shaped by the push and pull of lobbyists - representing a cornucopia of special interests - working with politicians and government agencies.
What makes this fight different, say Wall Street critics and legislative leaders, is that financiers are aggressively seeking to fend off regulation of the very products and practices that directly contributed to the worst economic crisis since the Great Depression. In contrast, after the savings-and-loan debacle of the 1980s, the clout of the financial lobby diminished significantly.
The current battle mirrors a tug-of-war a decade ago. Arguing that regulation would hamper financial innovation and send American jobs overseas, Congress passed legislation in December 2000 exempting derivatives from most oversight. It was signed by President Bill Clinton.
The law passed despite the strenuous objections of Brooksley Born, a former head of the Commodity Futures Trading Commission, who left the government after her unsuccessful effort to impose more regulation. In a recent speech, Ms. Born said big banks are again trying to water down oversight efforts.
"Special interests in the financial-services industry are beginning to advocate a return to business as usual and to argue against any need for serious reform," Ms. Born, now a lawyer in private practice, said at the John F. Kennedy Library in Boston, where she received a Profile in Courage Award.
After the 2000 legislation was passed, derivatives trading exploded, helping the biggest traders earn immense profits.
The market now represents transactions with a face value of $600 trillion, up from $88 trillion a decade ago. JPMorgan, the largest dealer of over-the-counter derivatives, earned $5 billion trading them in 2008, according to Reuters, making them one of its most profitable businesses.
Among the companies that expanded rapidly was A.I.G. Straying from its main business of providing property and life insurance, A.I.G. wrote a type of contract known as credit-default swaps that protected holders of mortgage securities against defaults. When millions of subprime borrowers stopped paying their mortgages, A.I.G. had to provide cash collateral that it did not have to clients that had bought its insurance.
Before the crisis, few market participants knew the size of A.I.G.'s exposure. Some derivatives transactions occur on exchanges, where the value and nature of the contracts are disclosed, but many do not. Credit-default swaps trade privately. This kept risk in these trades under wraps, leaving regulators unaware of how dangerously stretched and poorly managed the market was.
Where to Trade
On Capitol Hill, banking lobbyists have argued that derivatives should be traded on clearinghouses rather than exchanges, legislative leaders and their staffs say. The Geithner plan favors clearinghouses, where an intermediary would guarantee trades between participants, instead of participants dealing directly with one another as in an exchange.
A major New York clearinghouse is ICE U.S. Trust, an entity closely affiliated with banks that are also members of Mr. Rosen's group, the CDS Consortium.
Although the Chicago Mercantile Exchange is a more established place for derivatives trading and is independent from the big New York banks, ICE seems to be the clearinghouse of choice, especially among policy makers in Washington, said Brad Hintz, a brokerage firm analyst at Bernstein Research. That is because under the Treasury proposal, the Federal Reserve Bank of New York would oversee ICE, while the Commodity Futures Trading Commission would oversee the Chicago Mercantile Exchange. Critics say the Fed has been too easy on those it oversees.
Theo Lubke, a senior New York Fed official, countered Mr. Hintz's view, saying the Fed wants a market where a variety of clearinghouses can succeed.
Analysts say that because major banks that deal derivatives are so closely affiliated with ICE, they could seek to have many of the products classified as "customized" - the only category that would keep them off regulators' radar screens under Mr. Geithner's proposal.
This worries Mr. Harkin, the Iowa Democrat, whose constituents include agricultural concerns that want better oversight of trading.
This is needed, he said, to "add openness, transparency and integrity in futures trading to rebuild the financial system."
Letting "customized" derivatives - like many credit-default swaps - trade without detailed disclosure is a way to keep regulators in the dark, he said.
Mr. Harkin said Mr. Geithner visited the Democratic caucus on Capitol Hill three weeks ago. At that meeting, Mr. Harkin said, he challenged Mr. Geithner to "define customized swaps." Mr. Harkin said the Treasury secretary told him he would have to get back to him.
The big dealers, including major banks, say exchange trading would impose overly strict rules. But requiring exchange trading would have another effect: it would reduce the profits dealers make on derivatives.
Members of Congress say the lobbying efforts by big banks promise to produce one of the most intense political face-offs in Washington in years.
"The swaps and derivatives people are all over the place up here," Mr. Harkin said. "They sure are trying hard to win. A lot of money is on the line."
Lobbyists for the banks plan to make a renewed push on Capitol Hill this week.
The Financial Lobby
Through political action committees and their own employees, securities and investment firms gave $152 million in political contributions from 2007 to 2008, according to the most recent Federal Election Commission data.
The top five companies - Goldman Sachs, Citigroup, JP Morgan Chase, Bank of America and Credit Suisse - gave $22.7 million and spent more than $25 million combined on lobbying activities in that period, according to election data compiled by the Center for Responsive Politics.
All five companies are members of the CDS Dealers Consortium, the lobbying group formed in November. Lobbying records show that the group has paid Mr. Rosen, the Cleary Gottlieb partner, $430,000 for four months' work. Mr. Rosen declined to comment, a spokeswoman said, citing "client sensitivities."
Mr. Rosen, co-author of a treatise on derivatives regulation, frequently counsels the industry on these complex contracts. In late January, according to e-mail messages, he asked the members of the CDS dealer group if they would support his testifying before Congress on behalf of the Securities Industry and Financial Markets Association, a trade group. The CDS dealers are a much smaller group with a far larger interest in derivatives than Sifma as a whole.
Mr. Rosen received an e-mail response from Mary Whalen, managing director for public policy at Credit Suisse, the Swiss bank, which is active in the derivatives market:. "It is a good idea for Ed to write the testimony and if necessary testify. That way we can be sure that the banks' point of view is expressed, rather than taking a chance on testimony that Sifma might craft."
Sifma's members include 650 firms of varying size and interests, many of which do not trade complex derivatives. By taking the lead, Mr. Rosen was able to position himself as the main advocate on derivatives for the securities industry and to make sure that the group of nine banks in the CDS Dealers Consortium had a loud voice within Sifma.
A spokeswoman for Ms. Whalen declined to comment.
Testimony to Congress
At a House Agriculture Committee hearing on derivatives in February, Mr. Rosen testified on behalf of Sifma. He did not mention that he was also a paid lobbyist for the CDS Dealers Consortium, whose interests might be different from Sifma's.
Those testifying at such hearings are not required to disclose all of their affiliations. But when asked, Representative Collin C. Peterson, a Minnesota Democrat and the chairman of the House Agriculture Committee, said he had not known of Mr. Rosen's relationship to the consortium. He said he would have liked to have known because it would have guided his questioning and interpretation of Mr. Rosen's testimony, given that his clients in the smaller CDS group represented a narrower interest group with a more specific agenda.
Mr. Peterson, whose constituents include farmers, who are historically suspicious of Wall Street and whose livelihoods depend on efficient markets, is a longstanding critic of loose regulation. And since his committee oversees the Commodity Futures Trading Commission, he would retain more of his prerogatives overseeing the market if the C.F.T.C. were the main regulator.
Mr. Peterson's bill specifically bars derivatives trading in a clearinghouse regulated by the New York Federal Reserve, which he said in an interview "is a tool of the big banks" that "wouldn't do much" to regulate the contracts.
Because the banks' lobbyists persuaded some of his Republican colleagues to resist more sweeping changes, Mr. Peterson said, he has had to modify a bill he introduced that is similar to Mr. Harkin's in calling for wide-ranging limits on derivatives.
"The banks run the place," Mr. Peterson said. "I will tell you what the problem is - they give three times more money than the next biggest group. It's huge the amount of money they put into politics."
As a result of the lobbying efforts, champions of broad-based regulation are concerned that proposals will be significantly limited by banking interests.
"The outrage among the public means that things have a chance to change, if things move quickly," said Michael Greenberger, a professor at the University of Maryland Law School and a former director of trading and markets at the C.F.T.C. "We're in this brief moment of time when the average citizen is on a level playing field with the lobbyist."