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Treasury Secretary Geithner’s “Proposed OTC Act created new and significant loopholes”

From Michael Greenberger, former CFTC General Counsel, at the  Make Markets Be Markets conference. (HT Credit Risk Chronicles)

Pending Derivatives Legislation and Legislative Proposals

The Obama Administration White Paper
In response to the catastrophic systemic failure caused by unregulated derivatives, the Obama Administration in its June 2009 White Paper proposed that all standardized OTC derivatives be subject to clearing and exchange trading. It proposed that they be overseen in accordance with the traditional dictates of market regulation that had been in place since the New Deal and that were abandoned only in the deregulation of OTC derivative markets in 2000. The Administration also recommended that “[a]ll OTC derivatives dealers and all other firms whose activities in those markets create large exposures to counterparties should be subject to a robust and appropriate regime of prudential supervision and regulation,”17 including the imposition of increased capital requirements, business conduct standards, and auditing requirements.18

The Administration further proposed that so-called “customized” derivatives may remain traded as over-the-counter products. The Administration acknowledged the potential for exploitation that differentiated derivative regulation entails, and sought to close any perceived “customization” loophole through greater oversight over dealers in customized products. Treasury Secretary Geithner had said that criteria he would employ to distinguish customized from standardized derivatives would be, by design, “difficult to evade.”19 CFTC Chairman Gary Gensler also articulated a series of tests that would delineate standardized from customized instruments in a manner that would create a strong presumption that most of the existing OTC market would be deemed standardized and thus subject to exchange trading.20

In July 2009, a Blue Ribbon “Independent Task Force” composed of distinguished experts, i.e., the Investors’ Working Group co-chaired by former SEC Chairmen Arthur Levitt, Jr. and William H. Donaldson, reached many of the same conclusions as are found in the Obama Administration White Paper on regulating OTC derivatives.21

The Treasury’s OTC Derivatives Legislative Proposal

However, on August 11, 2009, the Treasury Department, on behalf of the Administration, submitted to Congress a specific legislative proposal (the “Proposed OTC Act”) in furtherance of its prior narrative recommendations. The Proposed OTC Act created new and significant loopholes that would undermine the Obama Administration’s stated goals for OTC derivative reform, namely, that the new regulatory structure “would cover the entire marketplace without exception.”22

On August 17, 2009, CFTC Chairman Gary Gensler, in a letter to Congress, critiqued the following exclusions suggested by Secretary Geithner, but not previously found in the Obama Administration’s narrative OTC reform proposals.

1. Foreign Exchange Swaps Exclusion. Chairman Gensler correctly explained: “The Proposed OTC Act would exclude foreign exchange swaps and foreign exchange forwards from the definition of a ‘swap’ regulated by the CFTC. The concern is that these broad exclusions could enable swap dealers and participants to structure swap transactions to come within these foreign exchange exclusions and thereby avoid regulation. . . .In short, these exceptions could swallow up the regulation that the Proposed OTC Act otherwise provides for currency and interest rate swaps.”23

Chairmen Frank and Peterson, leaders of the two committees of jurisdiction on this legislation in the House of Representatives, challenged the wisdom of this exclusion, claiming that it would eliminate from the exchange trading and clearing requirements over $50 trillion in swaps.24

This kind of exclusion has proven highly problematical. Recently, we have discovered that Greece and Portugal, and possibly Italy and Japan (if not many others), have used, inter alia, foreign currency swaps sold by U.S. swaps dealers as a vehicle for masking short term sovereign debt in order to, inter alia, gain entrance to the European Union in exchange of the case of Greece for paying swaps dealers hundreds of billions of dollars in Greek revenue streams extending to the year 2019.25 As one leading derivatives expert has noted, in these kinds of transactions, “the participant receives a payment today that is repaid by the higher-than-market payments in the future. . . Such arrangements provide funding for the sovereign borrower at significantly higher cost than traditional debt. The true cost to the borrower and profit to the [swaps dealer] is also not known, because of the absence of any requirement for detailed disclosure.”26

2. Exceptions from Mandatory Clearing and Exchange Trading for Non-Banks. The Treasury’s Proposed OTC Act included a further major and crippling loophole. As explained by Chairman Gensler, the Proposed OTC Act “creates an exception . . . from the mandatory clearing and trading requirements [if] one of the counterparties is not a swap dealer or major swap participant [(a non bank swap participant that does not present systemic financial risks.)] This excludes a major significant class of end users from the clearing and mandatory trading requirement.”27

Thus, by its clear language, the general regulatory protections in the Treasury’s Proposed OTC Act apply only to transactions between swaps dealers or between swaps dealers and other large institutions. As Chairman Gensler so correctly stated: “This major exception may undermine the policy objective[s] of lowering risk through bringing all standardized derivatives into centralized clearing . . . and increasing transparency and market efficiency though bringing standardized OTC derivatives onto exchanges . . . .”28

Of course, the end user exemption theoretically was dealt with in the Obama White Paper by recognizing that truly customized agreements with end users would not be subject to exchange trading and clearing. By nevertheless including an end user exemption without reference to customization, the Treasury bill completely ended the standardization/customization dichotomy by acknowledging that even standardized end user agreements (which could be exchange traded and cleared) would now not be regulated. In this regard, the Treasury proposal is more deregulatory than the 2000 CFMA, which requires that in order to be deregulated, a swap must be “subject to individual negotiation.”29 Eliminating the “subject to negotiation” requirement in the CFMA of 2000 resolved pending litigation in favor of the swaps dealers and ISDA, whose practice of claiming that its mandatory standard, boilerplate and copyrighted Master Agreement for swaps was “subject to individual negotiation” had been challenged in court.30

3. Thwarting State and Private Regulatory Enforcement. The August 11, 2009 Treasury legislative proposal also recommended — without explanation — maintaining the 2000 CFMA’s preemption of state gaming and anti-bucket shop regulation for unregulated OTC derivative products. As shown above, these OTC products are often marketed and used – not as hedging devices – but for pure speculation on future events. Since these instruments are unregulated on the federal level, states could (and should) readily view, for example, the purchase of a naked CDS guarantee on a CDO (which is in this case not owned by the “insured”) as gambling on the non-payment of mortgages by subprime borrowers in violation of state gambling laws. Similarly, many swaps dealers market “bets” on the upward movement of physical commodities, such as energy and food products, where the counterparty gains if the products rise in price, but loses if the price goes down.31 These commodity index swaps have been widely criticized as causing the huge upward price movement in physical commodities in defiance of market fundamentals. For example, Professor Nouriel Roubini describes the 2009 commodity spike as “money chasing commodities” and states that “[t]here is a risk that oil can rise to $80, $90 or $100 because of speculative demand,”32 thereby likely breaking the back of any economic recovery from the debilitating recession caused by the subprime meltdown. Indeed, on March 24, 2009, 184 U.S. based and international human rights and hunger relief organizations sent a letter to President Obama urging the “re-regulat[ion of] the food and energy [swaps] to remove excessive speculation that has so clearly increased price volatility in the last few years.”33 Again, the preemption provisions within the 2000 CFMA and supported by the Treasury tie the states’ hands at combating price distortions caused by betting on physical commodity prices.

In addition, the Treasury’s proposed August 11, 2009 language clarifies an ambiguity in the 2000 CFMA, making it clear that neither a private party nor a state can seek to void an illegal swap in either state or federal court. Under this provision, if a swap does not satisfy the requirements of the federal law under which the swap is governed, it nevertheless cannot be invalidated nor can damages be awarded on that swap. This “anti-voiding” provision advocated by Treasury creates a perverse incentive for a swap dealer to completely ignore the laws that otherwise govern the swap. Moreover, the Treasury anti-voiding language once again resolved an ambiguity in the CFMA in favor of ISDA and the swaps dealers, which is now at the heart of ongoing litigation.34

H.R. 4173, Title III (The House Derivatives Bill)
On December 11, 2009, the House passed by a vote of 223-202 H.R. 4173 in which Title III addressed the regulation of derivatives. While this bill is quite long and intricate, in general contours it follows the August 11, 2009 Treasury legislative proposals insofar as it: (1) includes the foreign exchange swap and non-bank end users’ exemptions – although upon joint agreement of the Treasury (which strongly supported the exemption) and the CFTC, the statutory foreign exchange swap exemption can be ended; (2) continues to preempt state gaming and anti-bucket shop laws for swaps that are not cleared and exchange traded; (3) ends the dichotomy between standardized and customized swaps, thereby ending the CFMA’s requirement that swaps exempt from exchange trading must be “subject to individual negotiations” and allowing standardized swaps for the first time to evade exchange trading requirements; and (4) continues to provide that swaps not complying with the statute can, nevertheless, not be voided if counterparties meet minimal net worth requirements.

Three further deregulatory measures crept into the House bill:

1. Swaps Execution Facility. First, while the bill continues to require that swaps not otherwise exempt must be exchange traded, at the behest of Wall Street lobbyists, the exchange trading requirement can be satisfied by placement of a privately executed swap on a “swaps execution facility,” which includes electronic trade execution or voice brokerage. While the electronic trade must be conducted by an entity “not controlled” by the counterparties, if the “SEF will not list the contract, it does not have to be executed.”25 In other words, the swap does not need to be exchange traded if it is submitted to a swaps execution facility that will not trade the swap. Pursuant to vigorous Wall Street lobbying, this SEF (introduced in House Agriculture Committee mark up) appears to undercut completely the bill’s and the Obama Administration’s exchange trading requirement.36 The provision for the SEF must be removed from any bill addressing the regulation of derivatives and swaps.

2. Abusive Swaps. In Chairman Frank’s discussion draft presented to the House Financial Services Committee markup, the legislation would have authorized the SEC and the CFTC to ban abusive swaps and then to jointly report such abuses to Congress.37 As reported out of the House Financial Services Committee Markup and as passed by the full House, the provision simply provided that the CFTC and SEC could jointly report abusive swaps to Congress38 – and deleted the authority to ban those swaps.

This substantial weakening of the “abusive swap” provision is quite significant. Even if the CFTC and SEC have the authority to enjoin swaps that are fraudulent and manipulative, the question may still arise whether those agencies can stop otherwise legitimate swaps that may not be fraudulent or manipulative but are destructive, nevertheless, to financial stability. The discussion above about CDSs and naked CDSs illustrates that those counterparties holding a CDS guarantee of a huge payout upon default of an instrument or an institution have an economic incentive to encourage the default. The classic case mentioned above is the holders of naked CDS guarantees who have bet that subprime mortgages will default have been accused of successfully lobbying against any legislation that would allow alteration of mortgage obligations to allow homeowners to stay in their homes. That conduct may not be fraudulent or manipulative. But it is highly abusive and federal regulators should have authority to ban that kind of destructive financial conduct – not simply “report” it to Congress.

Indeed, shortly after the House passed H.R. 4173, a further incident occurred that clearly demonstrated the need for federal regulators to ban abusive swaps. In order to avoid bankruptcy and the loss of 30,000 jobs, YRC Worldwide, Inc. (“YRC”) attempted to have certain of its bondholders convert their debt status to equity in order to clean up the YRC balance sheet. YRC is the largest U.S. manufacturer of trucks. Shortly before the deadline for conversion on December 23, 2009, the Teamsters Union, representing the YRC workers, discovered that certain Wall Street interests were marketing a strategy to defeat this rescue effort. Those interests were marketing a financial package that included the sale of the bonds in question along with CDSs that would pay off upon the bankruptcy of YRC. To profit from the package, the investor holding the bond would vote against the bond/equity exchange, triggering the bankruptcy with an accompanying huge payout on the YRC CDS.

On December 22, 2009, Teamster President James Hoffa sent a letter to state regulators calling for an investigation of this highly damaging financial package and held a press conference denouncing the attempt to profit from the destruction of the fragile U.S. manufacturing base and 30,000 union jobs just as the U.S. was trying to fight its way out of the recession. The deadline for the bond conversion was extended to December 31, 2009. Upon being confronted by the strong Teamster reaction, several of the Wall Street marketers of this financial transaction switched their position (i.e., voted for the bond conversion) and the company was saved shortly before the New Year.39 Several states are considering or have begun an investigation of this financial ruse.

Had the original House language authorizing the CFTC or SEC to ban abusive swaps been enacted into law, the YRC episode would have been a poster child for prompt federal action. As George Soros has recently said pertaining to the moral hazard associated with CDSs, “the market in credit default swaps . . . is biased in favor of those who speculate on failure. Being long on CDS, the risk automatically declines if they are wrong. This is the opposite of selling short stocks, where being wrong the risk automatically increases.” 40

3. Further Preemption of State Investor Protection Laws. It is ironic that the states, rather than the federal government, were willing to intervene to help the Teamsters Union defeat Wall Street’s attempt to use, inter alia, CDSs to drive the nation’s largest truck manufacturer into bankruptcy two days before Christmas. However, in addition to eliminating the CFTC’s and the SEC’s ability to ban abusive swaps, the House bill preempted state insurance laws as they apply to swaps.41 (Again, the House and the Treasury also supported continuing the preemption of state gaming and anti-bucket shop laws as applied to swaps not traded on exchanges.) As mentioned above, CDSs have all the characteristics of insurance policies. The states have begun to aggressively pursue a model state insurance law that would require CDS, inter alia, to be capitalized adequately and to ban “naked” CDS as illegal insurance that insures the risks of other parties. With almost no explanation, shortly before the H.R. 4173 went to the floor, Chairmen Frank and Peterson introduced the insurance preemption into the bill over the express objection of state insurance officials, including the National Council of Insurance Legislators, which is drafting the model legislation.42

Not only should the preemption of state insurance laws be removed from the derivatives reform legislation, but the preemption of state gaming and anti-bucket shop laws for swaps that are not exchange traded must be ended as well. Senator Maria Cantwell has introduced legislation ending the gaming and bucket shops preemption.43

Senate Derivatives Legislation
As of this writing, neither of the two Senate committees of jurisdiction (Banking and Agriculture) has introduced legislation concerning the regulation of OTC derivatives. On November 10, 2009, Senate Banking Chairman Dodd introduced a discussion draft of a financial regulatory reform bill that for the most part followed the template of the U.S. Treasury legislative proposal on derivatives but greatly restricted the exemption from exchange trading for those derivatives needed by end users to hedge commercial risk.44 After a hostile Republican reaction to the Dodd bill, the Chairman attempted to develop a bipartisan compromise. In recent days, it has been announced that a Senate Banking bill will emerge shortly – although it is unclear whether it will be fully bipartisan in nature.45 If it is a bipartisan bill, the derivatives portion is expected to be much more deregulatory than the House bill or the original Dodd proposal, especially by expressly eliminating any requirement that a swap not subject to the foreign exchange or end user exemption will only have to be cleared and it will not have to be exchange traded. As of this writing, the Senate Agriculture Committee has not yet indicated the legislative direction it will take on this issue.

Conclusion
Unregulated OTC derivatives have been at the heart of systemic or near systemic collapses — from the 1995 bankruptcy of Orange County; to the collapse of Long Term Capital Management in 1998; to the bankruptcy of Enron in 2001-2002; to the subprime meltdown and resulting severe recession in 2008, and now to the emerging sovereign debt crisis in Europe. After each crisis, governments worldwide proclaim that the OTC market has to be regulated for transparency, capital adequacy, regulation of intermediaries, self regulation, and strong enforcement of fraud and manipulation. But, aided by the passage of time, Wall Street always deflates those aspirations with aggressive lobbying. The present financial reform regulatory effort may be the only chance to get this issue right before the country devolves into a further financial quagmire with more bankruptcies and more job losses. A review of the House’s effort in this regard and present Senate proposals is not encouraging.

To avoid further systemic (and possibly irreparable) meltdowns, legislation must be enacted that:

  • Requires all standardized derivatives to be cleared by well-capitalized clearing facilities (to ensure capital adequacy and regularized marking to market of swaps). Legislation must require standardized derivatives to be traded on fully transparent and well regulated exchanges (to ensure price and trader transparency, regulation of intermediaries, self regulation, full disclosure and reporting (including having all derivatives “on balance sheet”). There must be strict anti-fraud and anti-manipulation requirements enforced by the federal government and the states, as well as private parties injured from such malpractices.
  • All swap dealers should meet strict capital and record keeping requirement, as well as business conduct rules.
  • Abusive swaps that are designed or marketed to cause economic injury and instability, e.g., forcing bankruptcies and unemployment, should be banned upon appropriate findings by the federal government.
  • There should be no federal preemption of state causes of action that protect consumers and investors from derivatives transactions that are not cleared or exchange traded, including state insurance, fraud, gaming, and anti-bucket shop laws.