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The inside story of how Goldman and the banks are getting clobbered on financial reform.

Some two dozen executives from large corporations will be descending on Capitol Hill today to make the case against over-regulating derivatives. The “fly-in” is being organized in part by the U.S. Chamber of Commerce through a group called the Coalition for Derivatives End-Users, according to the Chamber’s Ryan McKee. Many corporations use derivatives to hedge against fluctuations in the price of their inputs—for example, an airline might sign a contract to lock in future fuel prices, thereby passing the risk along to someone else. And so, on one level, it makes perfect sense that the executives and the Chamber would take an interest in derivatives legislation.

But, on another level, the pilgrimage by the so-called corporate "end-users" is a little mystifying. That’s because the legislation that’s piqued the executives’ interest—a derivatives bill that Senate Agriculture Committee Chairman Blanche Lincoln unveiled last week—explicitly exempts derivatives used in commercial activity, as in the jet-fuel example. What the Lincoln bill would regulate is the use of derivatives for more speculative purposes, like a straight-up bet between two Wall Street firms on the future price of oil.

Which suggests another explanation for today’s fly-in: Big financial firms like Goldman Sachs and JP Morgan generate billions of dollars each year as derivatives dealers. But, over the past several weeks, as Democrats’ have escalated their rhetoric and explicitly targeted Wall Street, the big banks have had trouble getting their message out on Capitol Hill. All the more so thanks to Friday’s SEC complaint accusing Goldman of fraud. “The banks’ credibility, their ability to influence this, is limited,” says one derivatives industry lawyer.

And so, instead of mostly making the pitch against regulation themselves, the big derivatives dealers are counting on their corporate clients to do a lot of heavy lifting for them. “The end user ability to do that is going to be pretty critical,” the lawyer says. “I think it would be naïve to think companies have not been talking to their bankers about how the business is going to be affected going forward.” That this conversation has yielded a well-coordinated trip so close to the endgame on financial reform is a sign of how much ground the banks have lost in such a short period of time.

The reason the recent developments are so remarkable is that all reforms tend to weaken as they get closer to passage, as legislators hash out compromises with powerful interests in order to secure a deal. Bizarrely, financial reform appears to be headed in the opposite direction. When it comes to derivatives, at least, the bill Senator Chris Dodd moved through his Banking Committee in March was significantly tougher than the bill the House passed in December. Then, last week, Lincoln shocked Wall Street by producing an even tougher bill than that. “This thing is not a battle they’d anticipated,” says one administration official. The industry had widely expected Lincoln to soften Dodd’s derivatives measure as part of a compromise with her Republican counterpart, Saxby Chambliss. (The Senate Banking and Agriculture Committees share jurisdiction over derivatives.)

What happened? For weeks, Wall Street had viewed the Dodd language as a placeholder while Lincoln and Chambliss hashed out the real details. Instead, the practical effect of the Dodd language was to create a minimum standard of toughness from which Democrats would be unwilling to retreat. As Lincoln and Chambliss bargained in March, the administration began to focus on the issue and discovered its popular resonance. “I have a clear memory of the time the House passed [its financial reform bill] in December. I directly tried to engage the White house … It was pretty much a non-event, primarily because of health care,” recalls Rep. Chris Van Hollen, who heads the House Democrats’ campaign arm. “It’s been a total transformation …  a quantum leap in engagement.” By the time Lincoln finally sent the administration the contours of a possible deal with Chambliss the week of March 29th, there was no way the deal could pass muster. Several days later, Michael Barr, the assistant Treasury secretary with the derivatives portfolio, told Lincoln's staff the administration would be unable to support it because it weakened the Dodd bill.

That left Lincoln with a dilemma: She’d been planning on moving the compromise through the Agriculture Committee with bipartisan support, meaning she could afford to lose a few liberal Democrats. Now that she’d be losing Republican votes to win the administration’s imprimatur, she’d have to construct a political coalition that would bring the liberals aboard. The result was the apparent lurch from what was widely expected to be the weakest derivatives bill on the Hill to what’s far and away the strongest.

That was last Tuesday. As of Thursday night, it still wasn’t entirely clear whether Lincoln had calibrated correctly. The bill was so much more hawkish than anything that had come before it—one provision could effectively ban big banks from trading derivatives outright—that it risked repelling not just Republicans but moderate Democrats. (Ben Nelson and Max Baucus both sit on Lincoln’s Agriculture committee.) Then came Friday’s Goldman revelations and suddenly Lincoln had the upper hand. “I’ve heard there’s been some folks on her committee pushing back a little bit,” says a former Democratic Senate aide who now consults for the financial services industry. But, “if you’re a Democrat, it’s harder to vote against something after the Goldman stuff. It puts pressure on Republicans and pressure on Democrats.”

This same person sees an analogy to Sarbanes-Oxley, the tough regulation of corporate accounting statements that Congress enacted after Enron. The bill had begun to stall in the Senate while its sponsor, Paul Sarbanes of Maryland, spent months methodically holding hearings. Then WorldCom imploded, and the bill became a juggernaut. “It was like a freight train. It was on the floor and no one was getting in front of it,” recalls the former aide. “Goldman to me is a little analogous… Except that [financial reform] was already on the track. It had some momentum. This helps give it a considerable amount more.”

At this point, the industry is banking on three things to save it: One is the efforts of the corporate executives visiting Capitol Hill today. It’s one thing to stiff-arm Wall Street not long after a financial crisis; it’s another to reject the pleas of companies who employ hundreds of thousands of people across the country (even if they may be talking Wall Street’s book). The second is that the mere passage of time may ratchet down tensions. “The current strategy that I’m hearing is basically to keep the Republicans together till cooler heads prevail,” says the derivatives industry lawyer. “Not to overreact to current events, not go too crazy.”

Finally, there’s the argument, which top Wall Street executives have conveyed directly to senior White House officials in recent days, that the administration faces almost as much peril as Wall Street does if it brings a partisan bill to the Senate floor. Should that happen, the argument goes, Senate liberals like Maria Cantwell and Byron Dorgan could triumph on amendments that would move the bill well to the left of where even the administration wants it. (In a telephone interview Monday afternoon, Dorgan allowed that he was “thinking through how to approach the too-big-to-fail piece” and that he might offer an amendment, though he was amused by the idea that it would represent a radical leftward thrust.)

Alas, it doesn’t look like the White House is biting just yet. “I think right now, everyone sort of sees it as win-win-win,” says a senior administration official. “Frankly, Rahm’s hearing from friends in the financial industry that he should cut a deal before it goes to the floor--that probably makes him less likely to do that, work this out. Rahm's like, ‘let's not work it out.’”

To be sure, Dodd continues to negotiate with Dick Shelby, his Republican counterpart on the Banking Committee, in the belief that he can strike a deal in exchange for only a handful of cosmetic, face-saving concessions. And, given the palpable anxiety on the Republican side, some Senate aides I spoke with think he’ll get it before the bill goes before the full chamber, possibly late this week. But, for the moment, the White House seems happier to make the banks and the GOP squirm. “Probably the way it's playing out … [we’d] make them vote a bunch of times against [a tough bill], then compromise. You’d still have a strong enough bill, but peel off five to ten votes to get it done.” The idea is to force Republicans to pay a price for their reflexive opposition--“make them actually block it, not just say they're going to block it”--before you finally throw them a lifeline.

The one tactical question Democrats do agree on is that the GOP is ready to crumple. Last week much was made of Senate Minority Leader Mitch McConnell’s success at getting all 41 Republicans to sign a letter of opposition to the current Dodd bill. But Democratic Senate aides have been privately mocking the letter’s mealy-mouthed language, which is carefully parsed to afford its signees maximum wiggle room. “There’s no explicit threat to vote against [opening debate],” scoffs one senior Democratic aide. “It pledges to continue negotiating.” If Wall Street has a few more sympathetic Main-Street execs up its sleeve, now would be the time to play them.

Noam Scheiber is a senior editor of The New Republic.

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