Streetwise Professor

December 11, 2014

The Height of Absurdity: The Operation of the Government Hinges on Blanche Lincoln’s Brainchild

Filed under: Commodities,Derivatives,Economics,Financial crisis,Politics,Regulation — The Professor @ 9:20 pm

There’s a whole lotta stupid in Frankendodd. A whole lot. The SEF Mandate is at the top of the list, but the “Swaps Pushout” isn’t far behind.

The Pushout was the brainchild of ex-Arkansas Senator Blanche Lincoln. (NB: I understand the risks of using “brain” in the same sentence as “Blanche Lincoln”.) Blanche, she of the historic 21 point annihilation in the 2010 midterms.

In brief, the Pushout required federally insured banks to move-“push out”-some swaps dealing activities to separate subsidiaries that do not have access to federal deposit insurance. This does not apply to all swaps, mind you. Not even to the bulk of them (interest rate swaps, many CDS). But just to commodity derivatives (other than gold), equity derivatives, and un-cleared CDS.

I took particular interest in this because-again-it slammed commodity derivatives. It was one of several provisions (position limits being another prominent example) that explicitly targeted commodities. Apparently the belief is that commodity derivatives are uniquely risky and subject to abuse, which is just untrue.

Consider a dealer making a market in a commodity index swap. That swap is easily hedged in the futures markets. Ditto with a NYMEX lookalike gas or oil swap. Yes, maybe an unhedged commodity swap is riskier than your typical unhedged IRS, but so what? That’s not the way dealers typically trade (they typically run matched books, or nearly matched books), and capital requirements and other regulations mean that riskier positions incur additional costs that mitigate the incentive to take on excessive risks.

So commodity derivatives (or equity derivatives) don’t create exceptional risks that justify exceptional treatment. What’s more, creating stand-alone affiliates to handle this business entails additional costs. More people. Duplication of infrastructure. Additional capital. There are also scope economies (deriving in particular from capital efficiencies that arise from greater netting opportunities that arise from holding multiple, relatively uncorrelated, positions in a single book). Sacrificing those scope economies will lead to fewer commodity swaps dealers, which in turn makes hedging costlier and the market for these swaps less competitive.

In other words, like many parts of Frankendodd, the Pushout was all pain, no gain. And the pain, mind you, will be suffered not so much by the dealer banks, but by the firms in the real economy that use commodity derivatives to hedge their price risks.

That said, it never seemed to be that big a deal, given the relatively small scale of commodity derivatives and equity derivatives in comparison to IRS and other trades that banks were allowed to keep on the books of insured entities. Small beer compared to the rest of the havoc wreaked by the rampaging Frankendodd Monster.

But this obscure provision could be the one that brings on yet another government shutdown. The most hardcore lefties in the Senate (e.g., Elizabeth Warren) and the House (e.g., Maxine Waters) have drawn a line in the sand over the part of the “Cromnibus Bill” that would repeal the Pushout. If passed, “Cromnibus” would fund the government (except DHS) for the next year, thereby avoiding another shutdown.

But claiming that eliminating the Pushout would be an unconscionable capitulation to Wall Street, the lefties are going to the barricades, and threatening to bring DC to a grinding halt rather than let the Pushout bite the dust. This is not about substance, but symbolism. It is also about a defeated party carrying out a rearguard action on ground where its most rabid partisans can rally.

You cannot make up this stuff. Blanche Lincoln’s populist hobby horse, a desperate effort by a doomed politician, could be the pretext for yet another unproductive partisan confrontation that has virtually nothing to do with the more serious issues associated with funding the government for the next year. (If the Pushout hadn’t passed, would Lincoln have lost by 25 points or 15, rather than 21?) (I note that Gary Gensler worked very closely with Lincoln on Frankendodd: “During drafting sessions, Gensler sometimes sat at the table reserved for staff, advising its Democratic chairwoman, Blanche Lincoln of Arkansas.”)

Cromnibus raises very serious issues. The Swaps Pushout isn’t one of them. But rather than joining the debate on the real issues, or conceding their thumping at the polls, demagogic progs are screaming Swaps Pushout or Fight.

What a travesty.

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  1. I’ve always thought that, as you say, the pushout rule is no big deal, but why did the big banks, led by Citibank, take this to the wall? Are we missing something, or is it just that they thought it was a winnable battle, and a good start down the slippery slope to dismantling other parts of Frankendodd?

    Comment by Kiffmeister — December 12, 2014 @ 12:23 pm

  2. SWP:

    Politically there may be an unforeseen silver lining on this cloud of a gov’t shutdown: even one engineered by Fauxcahontis Warren, the new darling of the 2016 Left. Media is mum on gov’t shutdown they have been banging the drum on back in the good “old” days of 24 hours ago. Political half life of the MSM platform is fun to watch.


    Political theater may get very interesting for political junkies if they scuttle this deal. All bets are off if Reid & Boehner can’t hold this together.

    VP VP

    Comment by Vlad — December 12, 2014 @ 12:38 pm

  3. Interestingly I came across this piece from the Reuters “Practical Law” service that singles out Citibank and JP Morgan as the main targets of the push-out rule. It’s also a nice summary of the details that everyone else glosses over so as not to muddle our poor little heads:

    Comment by Kiffmeister — December 12, 2014 @ 12:50 pm

  4. I too would like more of your input on why if its small beer did Citi push so hard to include it? Actually if you dont mind, although its clear you think very little of the FrankDodd how would you prefer to avoid/mitigate the next 2008?

    Comment by d — December 12, 2014 @ 8:57 pm

  5. SP, How about a post on where you think the commodity trading business is going. I see Andy Hall is out and Phibro may close it’s doors, that to me is amazing since Phillips Brothers was a huge trading empire at one time.

    Comment by TomHend — December 13, 2014 @ 7:17 pm

  6. Thanks for sharing!

    Comment by Findia Group — December 15, 2014 @ 1:41 am

  7. Thanks for including me as a “prog”!!

    Comment by David Vitter — December 15, 2014 @ 10:18 am

  8. @”David Vitter” (yeah, right). WTF does that have to do with the Swaps Pushout?

    The ProfessorComment by The Professor — December 15, 2014 @ 8:07 pm


    Comment by David Vitter — December 16, 2014 @ 7:05 pm

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