Legislation would bar taxpayer bailouts of derivatives ponzi schemes

April 15 (Bloomberg) — Goldman Sachs Group Inc., JPMorgan Chase & Co. and their biggest rivals would be forced to wall off derivatives trading operations from their commercial banks under a measure to be introduced by Senate Agriculture Committee Chairman Blanche Lincoln, a congressional aide said.

Lincoln, an Arkansas Democrat, will propose a “no-bailout provision” as part of an overhaul of derivatives regulation she plans to unveil today, according to the aide, who declined to be identified because the plan isn’t public. The measure aims to ensure banks don’t endanger depositors’ money with risky trading of over-the-counter derivatives, the aide said.

The proposal is already drawing opposition from banks that dominate the $605 trillion over-the-counter market. Derivatives regulation being weighed by Congress could cost JPMorgan from “$700 million to a couple billion dollars,” Jamie Dimon, the bank’s chief executive officer, said yesterday during a conference call with analysts.

“I imagine their lobbyists have already contacted their best contacts in the government,” said Darrell Duffie, a finance professor at Stanford University in Palo Alto, California.

The five biggest dealers in the largely unregulated market — all commercial banks — earned $28 billion from derivatives trading last year, according to reports collected by the Federal Reserve and people familiar with the matter.

Tougher Than Obama

Lincoln’s provision would bar swaps dealers from taking advantage of the Federal Reserve’s discount lending window, emergency liquidity functions and the Federal Deposit Insurance Corp.’s deposit guarantee.     “It eliminates all of the advantages with the affiliation with an insured depository institution, which are profound,” said Karen Petrou, managing partner of Washington-based research firm Federal Financial Analytics Inc.

President Barack Obama met with House and Senate leaders at the White House yesterday, pushing them to finish work on the regulatory legislation he proposed last June. He said the bill must include strong oversight of the derivatives market, which he described as an “enormously risky” part of the shadow economy.

Lincoln’s bill is tougher than what Obama has proposed for derivatives oversight and could complicate efforts to pass a broader regulatory overhaul bill, lawmakers said yesterday. It would have to be approved by the Agriculture Committee and then incorporated into the broader regulatory-reform bill drafted by Senate Banking Committee Chairman Christopher Dodd. Dodd’s was approved by the banking panel last month on a 13-10 vote without Republican support.

Moderate Democrat

Lincoln, a moderate Democrat who has campaigned in Arkansas on her independence from party leadership, is facing a tough primary election fight, with members of the progressive wing of the Democratic Party like MoveOn.org attacking her for being too close to Wall Street.

Senator Judd Gregg, a New Hampshire Republican, expressed frustration that a deal between Lincoln and Senator Saxby Chambliss of Georgia, the Agriculture panel’s top Republican, had fallen apart under White House pressure. Gregg indicated the derivatives bill wouldn’t get Republican support.

“Obviously all bets are off,” said Gregg, who spent months in Banking Committee negotiations that failed to yield agreement on derivatives language.

Republicans signaled that they will oppose Dodd’s bill, which they said won’t prevent taxpayers from having to prop up failed financial firms in the event of a future economic crisis.

“It’s a bill that actually guarantees future bailouts of Wall Street banks,” Senate Republican Leader Mitch McConnell old reporters after meeting with Obama.

Spin Offs

Along with forcing commercial banks to spin off their swaps dealers to a different corporate entity, Lincoln’s derivatives legislation would bar dealers, exchanges, clearinghouses and other swaps-market participants from being able to take advantage of emergency lending from the Fed, according to the aide.

It would also increase protections for clients by requiring swaps dealers to treat them as a fiduciary — obligating them to put customers’ interests ahead of the company’s, the aide said.

The measure requires most over-the-counter derivatives to be traded on exchanges or through clearinghouses. Companies that use swaps to hedge the cost of materials or other non-investment purposes would be exempted from the requirements, the aide said.     Like the Volcker rule, which would ban commercial banks from proprietary trading, the wall-off provision would separate derivatives trading from traditional banking activities such as taking deposits and making loans.

Cheaper Funding

It is also an effort to crack down on the possibility that banks would use cheaper funding provided by deposits insured by the FDIC. to subsidize their trading activities, the aide said.

The proposal, which would affect 25 to 30 banks that trade derivatives, is likely to generate strong opposition, analysts said. Along with Goldman Sachs and JPMorgan, the other three banks that control almost all swaps trading are Morgan Stanley, Citigroup Inc. and Bank of America Corp.    “With 97 percent of OTC derivatives housed in the five biggest banks, it tells you how critical it is for the business model to be affiliated with a really big bank,” said Petrou of Federal Financial Analytics.

Treasury Secretary Timothy F. Geithner, speaking at the White House yesterday, said Lincoln’s plan was promising.

“Based on what she has laid out in public, it looks like a very strong bill, very close to where we are,” Geithner said.

To contact the reporters on this story: Robert Schmidt in Washington at rschmidt5@bloomberg.net; Phil Mattingly in Washington at pmattingly@bloomberg.net.