Cross posted from The Accidental Hunt Brothers

The world financial system nearly melted down in 2008. This was a result of the interlocking web of exposures between major financial institutions caused by the unregulated and completely opaque over-the-counter (OTC) derivatives market. The U.S. taxpayer was forced to pledge nearly $24 trillion in cash and loan guarantees to avert financial Armageddon. That amounts to approximately $200,000 for every household in America!

Even though the system was saved from total collapse, still the economic pain inflicted upon America and the world was devastating. Trillions of dollars in savings were obliterated and millions of jobs were destroyed as the world’s economy was crushed. All of this could have been averted if OTC derivatives had been properly regulated.

The risk to our financial system must be eliminated, not simply regulated. We as Americans should not tolerate our system being put at risk. All OTC derivatives should clear through a Central Counterparty (CCP) with novation and daily margin, so that all swaps counterparties are forced to make good on their bets every day.  In addition all derivatives that can trade on a public exchange should trade on a public exchange so that regulators have real-time transparency and the ability to police these markets for fraud and manipulation.

But barely one year after they were staring at Lehman-style bankruptcy, swaps dealers (the perpetrators of the financial crisis) are already rejecting this strong medicine.  They are prioritizing their short-term profits and million dollar bonuses over the long-term health of the financial system.  In fact these recipients of TARP money have spent $344 million in 2009 alone to defeat derivatives reform regulation.

More than anyone else, Wall Street knows a good investment when they see it.  So what is their $344 million buying them?  At least 4 humongous loopholes in the derivatives reform legislation being voted on in the House of Representatives this week:

Loophole #1 ::  Foreign Exchange Exemption  :: Foreign Exchange exposure represents approximately 8% of total Over-The-Counter (OTC) Derivatives Exposure.  (see Loophole Calculations spreadsheet for methodology)  By exempting Foreign Exchange from clearing this leaves a big portion of the market uncleared thereby adding to systemic risk.  Think of it this way, would you be happy to know that for every 100 people boarding your airline flight, there were 8 people that did not have to pass through the metal detectors?

Loophole #2 ::  End-User Exemption  :: The swaps dealers have mobilized their corporate clients to oppose mandatory clearing in order to avoid posting margin on their trades.  It turns out that Corporate America likes Off Balance Sheet Financing just as much as Wall Street!  Because notional values do not represent true exposure and because end-users trade much less frequently and typically leave their trades on until expiration, there is little or no compression of the end-user notionals.  Therefore by excluding end-users from clearing we believe that Congress is excluding between 16% and 21% of all derivatives exposures.  Combined with the Foreign Exchange exemption now these two loopholes result in 24-29% of OTC derivatives going uncleared.  The risk to the financial system is growing much larger with every loophole.

Loophole #3 ::  “Balance Sheet Risk” Exemption  :: “Balance Sheet Risk” is code for “interest rate hedging through swaps.”  By exempting anyone using interest rate swaps for hedging balance sheet risk we estimate that you are excluding about half of all of the dealer-to-financial interest rate derivatives (on top of the previous end-user exemption).  This means that under this loophole another 15% to 16% of all derivatives exposures goes uncleared.  Combining all three loopholes together Congress is effectively exempting between 40% and 45% of all derivatives from clearing.

If all three loopholes are incorporated in the final bill then just over half of all derivatives will be moved into clearing, while nearly half will escape from mandatory clearing due to successful lobbying in Washington.

Loophole #4 ::  Alternative Swaps Execution Facility  (ASEF)  :: Congress has also bowed to Wall Street’s request to allow them to avoid trading on a public exchange altogether.  Instead swaps dealers can use ASEFs instead of exchanges.  And the word “execution” in the term ASEF is misleading because Congress has allowed some high-powered lawyer/lobbyists to twist the definition so that “voice brokerage” is an ASEF (meaning calling your client on the telephone) and all the ASEF is used for is confirming or reporting the trade, not actually executing the trade.  As a result 100% of all OTC derivatives can trade through ASEFs.  They don’t have to trade on a public exchange at all.

So it’s clear what $344 million in lobbying buys you.  In addition to multiple Congressmen and Senators it buys you a series of loopholes that allows you to avoid about half of the clearing requirement and all of the trading requirement in the derivatives reform bill.  This is a fantastic investment (less than 1%) when derivatives represent $35 billion per year in revenue!!

Thanks to the Wall Street banks that nearly blew themselves up last year, the derivatives regulation reform bill that was supposed to fix these problems is actually just papering over the mess, without bringing the strong regulation that America desperately needs.  Passage of the House Bill with the current gaping loopholes is no guarantee that our financial system will not be back on the brink of disaster within ten years.

UPDATE: All these loopholes made it into the final House version which will be voted on today.