Dems Break GOP's Attempted Filibuster in the Senate, But Proposed Wall Street Reforms Are Pretty Flimsy

The Republican Party finally acknowledged on Wednesday that it is unwilling to alienate voters by continuing to block even debate on Wall Street reform. The good news: Democrats do not appear to have given much ground on negotiations this week as Republicans threw up their blockade. The bad news: without significant strengthening, the financial reform bill advanced by Sen. Chris Dodd, D-Conn., will be too weak to end big bank abuses.

The legislation that cleared the Senate Banking Committee in March appears to have undergone two key changes amid this week's GOP filibuster. Only one of these changes is a concession to Republicans. The other change is an unnecessary giveaway to Wall Street that Democrats have concocted on their own.

Let's start with the self-inflicted wound. Dodd's effort to rein in derivatives -- the crazy contracts that killed AIG -- wasn't very good, but a competing bill from Sen. Blanche Lincoln, D-Ark., was much better. When Democrats combined the two bills this week, they kept many of Lincoln's strong provisions, but ditched one very important rule. Lincoln would have banned any derivatives that constitute outright gambling. Some derivatives help companies hedge risks, but others are just straightforward bets a Las Vegas bookie could set up for you. This is the kind of trading that got Goldman Sachs into trouble with the Securities and Exchange Commission. But the SEC isn't accusing Goldman of fraud for gambling, it's accusing Goldman of fraud for lying and gambling, which is why Lincoln's language would have helped.

So it's a bummer that this provision is now gone. But it gets worse. The biggest source of trouble with derivatives is the fact that the entire market operates in secret. Banks trade with each other, and that's the end of it. Nobody else in the market verifies the trade, and no regulator supervises it. There are two ways to deal with this, and ideally, we'd use both. First, we can simply ban abusive or risky trades (that is no longer included in the bill). Second, we can shed some light on all trades by requiring market players to sign off on them, and let regulators watch over the trades. This would ensure that no company -- let's call it AIG -- builds up trillions of dollars in risky bets it cannot possibly make good on.

This process is called "central clearing." If AIG can't pay off its bet with another company, then a "central" party that "cleared" the trade will pay it off for them. That prevents a cascade of defaults that can bring down the entire economy. Central clearing alone is not enough to fix the derivatives market, but the market can't be fixed without central clearing.

Lincoln's bill required central clearing for almost every derivatives trade, and the Dodd-Lincoln mash-up includes that language. Unfortunately, it also includes a brief section that completely undercuts that new rule. (For wonks, it's Section 739, paragraphs A and B.) Under the current bill, there is no penalty for anybody who fails to centrally clear their trades—even though the bill labels this activity illegal. What's more, even though this behavior is illegal, the trade itself is still valid. In other words, banks are required to bring their trading into the open. But if they don't shed light on their trades, nothing will happen to them. I wonder what banks will choose.

"That's breathtaking," says Michael Greenberger, who served as Brooksley Born's top deputy at the Commodity Futures Trading Commission during the late 1990s. "It's essentially telling the world that we have all of these rules, but we aren't going to enforce them." Born and Greenberger spearheaded an effort to regulate derivatives during the Clinton years that was thwarted by Alan Greenspan, Larry Summers and Robert Rubin.