The Blue Dog: Money Man's Best Friend

The Obama administration promised to reform the financial system and
make it safe for the rest of us, but recent Congressional action is more
likely to reset the fuse for another explosive calamity. The time bomb
in this case is that arcane financial instrument known as
derivatives--the hedging devices that the big banks sell to investors,
corporations and other banks to reduce risk or evade the requirements to
hold adequate capital on their books.

As the financial meltdown demonstrated, derivatives do not reduce risk.
They amplify it and spread it around interlocking networks of unwitting
investors. That house of cards collapsed worldwide a year ago. It would
be tragic to let the bankers build a new one. Some reformers think all
but the simplest, most visible forms of derivatives should be prohibited
by law. The president prefers instead to regulate them. Derivatives, his
advisers explained, would be less dangerous if they were traded openly
in financial markets, just like stocks and bonds. Regulators could then
put the brakes on dangerous excess if they saw it developing. Anyway,
that was the theory.

But the "reform" legislation approved by the House Financial Services
Committee on October 15 is a fiesta of exemptions, exceptions and
twisted legalese that effectively defeat the original purpose. Only
experts can divine the actual meaning of the bill's densely worded
provisions, and many of them have reacted with disgust. The
"entanglements of derivatives exposures" among oversize banks "is the
equivalent of the San Andreas Fault of our financial system," veteran
financier Robert Johnson testified at an October 7 hearing on the draft
bill. If Congress does not disarm derivatives, he warned, it could lead
to another cascade of failure that would give regulators no choice but
once again to rush to the rescue of the banks dubbed "too big to fail."

That risk is not theoretical. The largest banks that dominate this
lucrative business seem to have gotten pretty much what they wanted--a
free hand to keep peddling the indecipherable derivatives beyond the
reach of regulators. According to the Financial Times, Goldman
Sachs plans to market a new financial instrument that will allow banks
to reduce the capital required to hold risky assets on their balance
sheets. Goldman calls this product "insurance" and expects to sell it to
the banks with toxic portfolios, enabling them to shift the risk off
their balance sheets. It is not clear whether the new bill will
interfere with this "innovation." Goldman evidently does not see a

Who drafted this dubious piece of legislation? Bankers (or their
lawyers) did. The leading sellers of derivatives are an exclusive club
of five very large financial institutions--Citigroup, JPMorgan Chase,
Bank of America, Morgan Stanley and Goldman Sachs--that hold 95 percent
of the derivatives exposure among the largest banks (the total contract
value exceeds $290 trillion). These are the same folks who toppled the
global economy and compelled government to intervene with gigantic

Michael Greenberger, a University of Maryland law professor and veteran
federal regulator, studied the House committee's 187-page bill and
detected the fine needlework of Wall Street lawyers. "It had to be
written by someone inside the banks," Greenberger said, "because buried
every few pages is a tricky and devilish 'exception.' It would greatly
surprise me if these poison pills originated from anyone on Capitol Hill
or the Treasury."

A well-informed Congressional source confirmed that the original
language in the draft legislation was written by financial-industry
experts. It "was probably written by JPMorgan and Goldman Sachs," he
told me, "and possibly the Chicago Mercantile Exchange." The Chicago
exchange trades commodity futures--hog bellies, beef, grains--and more
exotic derivatives. It is a rival to Wall Street but very close to
agribusiness interests like Cargill, the giant grain trader, that make
heavy use of derivatives.

Washington insiders may not be shocked to learn that private-interest
groups provided the draft bill. This is what lobbyists often do for the
legislative process, especially on complex subjects like taxation and
regulatory law. But the legislation was delivered to the House Financial
Services Committee by Blue Dog Democrats, not lobbyists. There are
fifteen Blue Dogs and like-minded members on the committee. Together
they make up more than one-third of the committee's Democratic majority
(forty-two Democrats, twenty-nine Republicans).

"The conduit for the draft text was Blue Dogs and conservative
Democrats," my source explained. "The committee could not do anything
without them," since the Republicans were committed to voting against
whatever the Democrats proposed. Chairman Barney Frank made a deal to
accept the Blue Dogs' original draft as the starting point, hoping to
improve on it with amendments. The chairman made progress, but the
finished bill is still vulnerable to whatever evasive games Wall Street
decides to play.

The Blue Dogs claimed they were speaking for business, not bankers, but
this too involved a little sleight of hand by industry lobbyists. Last
summer, an official of the Securities Industry and Financial Markets
Association told colleagues at a private industry meeting that since the
bankers have damaged credibility in Washington, they should send their
customers to push the bankers' position on Capitol Hill. Sure enough,
representatives from various industrial and agricultural sectors showed
up to testify as expert witnesses and demand exemption from regulation
as the "end users" of derivatives. Bankers told their clients that
regulation would raise their costs. Never mind the costs to the country
if derivatives blow up again.

The ploy seems to have worked. The exemption for "end users" contained
in the committee's final legislation is a major loophole--so vaguely
defined it exempts insurance and mutual funds and might even be
construed to protect hedge funds and private-equity capital from the
disclosure of trading derivatives on public exchanges. Some committee
members know very well they failed to eliminate crucial exceptions.
Frank's commitment to reform is in question, since he voted for the
original deregulation of derivatives in 2000. Now he says he wants to
offer strengthening amendments when the bill comes to the House floor
for passage. He has asked regulators at the SEC and the Commodity
Futures Trading Commission to recommend ways to close loopholes "to
prevent speculators from masquerading as end-users."

The odor of money hovers over the Blue Dogs--political money for their
next campaigns. The House Financial Services Committee is a prized
assignment and known informally among members as a "money committee,"
not because it deals with money issues but because its members have an
easier time raising campaign funds from the banks and financial firms
under their jurisdiction. This is not illegal. It is the way Congress

Money also explains why the committee is top-heavy with Blue Dogs. House
Speaker Nancy Pelosi put them there, along with other freshmen and
sophomores, knowing it can help them win re-election. She was encouraged
by Representative Rahm Emanuel, now White House chief of staff, who was
then chair of the Democratic Congressional Campaign Committee. In 2006
and again in 2008, Emanuel had a lot to do with electing Blue Dogs to
House seats the Democratic Party was not supposed to win--suburban and
rural districts normally represented by Republicans. Emanuel recruited
candidates, coached them and financed them. They helped Democrats win
control of the House and helped Pelosi become Speaker. Many of them face
tough re-election fights in 2010 and need to raise a lot of money to
survive. Naturally, party leaders worry about keeping them.

These more conservative junior members, one might say, are the tail
wagging the committee's older, more liberal dogs. The Democratic Party
is stuck with the consequences. It is a reform party that wants to have
it both ways--serving the public interest without overly discomforting
the bankers. The dilemma poses a test for Pelosi: will she stand with
her favored Blue Dogs or go with the progressive/liberal majority of
Democrats who want to solve the problem?

The House legislation essentially reflects the strategic choice
President Obama made about financial reform. He wants to rearrange the
regulatory system in Washington, but he does not want to alter the
fundamental structure of the financial system or prohibit banking
practices known to be dangerous. Instead of proposing hard rules and
specific limits on bankers, the president would empower the regulatory
agencies to keep watch and put the Federal Reserve in charge of guarding
against systemic risk. Advocates of this approach argue that lawmakers
do not know enough to write legislative commandments. There is some
truth to that, but why imagine that regulators know what to do? Or that
they will have the nerve to impose tougher rules that Congress declines
to enact?

The Fed, in particular, failed utterly to see the developing crisis in
advance or to listen to warnings from those who did. Again and again
during the last twenty-five years, the Federal Reserve worried privately
about banking excesses but never stepped up to restrain the reckless
behavior until it was too late. Then, in crisis, the central bank rushed
to the rescue and bailed out the largest of the bad actors.

But skepticism is rapidly gaining momentum in Congress. The most
noteworthy critics of Obama's relatively limp reforms are two former
Federal Reserve chairmen--Paul Volcker and Alan Greenspan--who in
different ways recommend far stronger actions to correct things. Volcker
wants to peel back a generation of permissive deregulation and restore
the traditional format in banking: prevent commercial banks, whose
deposits are insured by the government, from taking risky adventures in
financial markets. Do not give more responsibility to the Fed, so it can
focus on its core function--the conduct of monetary policy.

Greenspan now calls for anti-trust enforcement to break up the
mega-banks--the very behemoths he helped create as Fed chairman. "If
they're too big to fail, they're too big," he told the Council on
Foreign Relations on October 15. "In 1911, we broke up Standard Oil. So
what happened? The individual parts became more valuable than the whole.
Maybe that's what we need to do." These declarations may read as belated
expressions of regret, but they have serious influence in Washington.

In the Senate, both the chairman of the Banking Committee, Christopher
Dodd, and the ranking Republican, Richard Shelby, think putting the
Federal Reserve in charge of regulators would be a mistake. On November
10 Dodd unveiled a draft bill that strips the central bank of its
regulatory function and creates a new overarching regulatory
administration that pre-empts existing agencies. Shelby argues further
that the Fed should be reorganized to eliminate the role of private
bankers in making internal decisions at the twelve regional Federal
Reserve banks (Dodd would require Senate confirmation for presidents of
those banks). "I believe this is an inherent conflict," Shelby said,
"because the banks decide who will be their regulator. I don't think
that's a healthy thing." Senator Bernie Sanders, always the point man
for big ideas, proposes that the Treasury be required to identify and
dismantle banks that are too big to fail.

Amid the usual cast of characters, a strong new voice showed up this
season to advise Congress--Richard Trumka, the new president of the
AFL-CIO. "Our members were not invited to Wall Street's party," Trumka
told the House Financial Services Committee, "but we have paid for it
with devastated pension funds, lost jobs and public bailouts of
private-sector losses. Our goal is a financial system that is...the
servant of the real economy rather than its master."

Trumka too objects to Obama's plan to put the Federal Reserve in charge
as super-regulator--at least until the central bank is reformed,
stripped of banking insiders and made democratically accountable.
"Giving the Federal Reserve, with its current governance, control over
which financial institutions are bailed out in a crisis is effectively
giving the banks the ability to raid the Treasury for their own
benefit," he warned.

Strong words, but Trumka's critique is a better fit with reality and the
public's angry mood than anything heard from the White House or
Congress. As recent election returns suggest, if the president continues
to soft-sell reform, he is at risk of being identified with the old
order in Wall Street. The longer Congress tries to placate the bankers
with meek reforms, the sooner Democrats will discover this is really
dumb politics.

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