The $40 billion gift that Wall Street doesn't deserve

The esoteric financial products known as derivatives are so risky that they were once called “financial weapons of mass destruction.”

Derivatives were central to the near-failures and bailouts of the giant hedge fund Long-Term Capital Management in 1998 and the insurer AIG in 2008. A rogue derivatives trader bankrupted the British bank Barings in 1995, and JPMorgan’s notorious “London Whale” trader lost more than $6 billion in trading derivatives in 2012.

In light of this, anyone remotely familiar with the troubled history of derivatives would be horrified to learn about the recent effort by financial regulators and lawmakers to roll back an important safeguard implemented after the financial crisis, giving big banks a $40 billion windfall in the process and leaving taxpayers, once again, holding the bag.

Wall Street likes to run its derivatives business out of foreign legal entities because it is more lightly regulated in other countries. LTCM booked its trades in the Cayman Islands, AIG and JPMorgan booked theirs in London. Banks then consolidate all of their trades by making a trade between affiliated entities — from their foreign office to their federally insured banks located in the U.S. — so they can access all of the company’s financial resources and have the support of the U.S. government.

To protect taxpayers from the risks of trades between affiliates within the same ownership structure, bank regulators require U.S. banks to collect and hold high-quality assets, known as “margin,” to cover losses.

Margin is the first line of defense for any trade, and a derivative that is not backed by margin is essentially an unsecured loan. If a trading partner runs into financial trouble, there could be temptation to walk away from derivative payments, even if it’s owned by the same parent company.

These margin rules are what big banks and their allies have been lobbying to reverse, and to use the $40 billion currently backing their trades to invest as they please, including paying out shareholder dividends or executive bonuses.

Margin isn’t foolproof. It’s based on assumptions and projections. So banks need a second line of protection through equity funding that can absorb losses in unforeseen circumstances.

Adding to the danger of the margin proposal, regulators have also suggested releasing $121 billion in equity from the eight biggest megabanks. To give a sense of the potential risks involved, three of the four largest banks that dominate the derivatives market have exposures that exceed their total capital — one of them two times over.

If these changes are allowed to go through, taxpayers will have $161 billion more exposure to Wall Street’s risky bets. If banks have weaker financial resources and their trading partners default on their promises, banks will come calling to the Federal Deposit Insurance Corp. for support. Taxpayers will have to cover the FDIC’s losses. And Main Street community banks will be asked to help replenish the FDIC’s insurance fund.

Of course, big banks are too smart to argue that this deregulation should be done for their benefit. The proposal is intended to juice banks’ lending, leading to more “economic growth” and, by extension, jobs for working people.

Yet, it is hard to square these alleged benefits with the fact that the banking industry is already making record profits and paying out billions of dollars to their shareholders. If banks are being constrained by having to post margin, they are not behaving like it.

Perhaps the most perplexing part of this effort is the fact that it recently won the backing of a group of Democratic lawmakers in “swing” districts. These members likely see it as a way to convince some Trump voters to support their re-elections.

However, before President Trump staffed his administration from Goldman Sachs’ C-suite, he ran as an anti-Wall Street candidate. He understood that looking like a friend of the big banks is not the way to win over swing voters.

Indeed, supporting bank deregulation was not a path to re-election for a number of vulnerable Democrats in 2018, while bank opponents coasted to re-election in a handful of Trump states.

Any policymaker considering giving a $40 billion gift to the Wall Street banks should instead keep the money. If history is any guide, we’re going to need it.