Good Riddance to (most of) the Swaps Push-Out Rule

Congressional sausage making. Hopefully, by tomorrow evening (Friday, December 12th, 2014), both chambers of Congress will have successfully avoided yet another unpopular government shutdown by having passed the Consolidated and Further Continuing Appropriations Act, 2015. The CRomnibus (Congressional slang for "continuing resolution omnibus") spending bill will fund the government through September 30, 2015, the end of the 2015 fiscal year. This bill - like virtually all spending bills before it - is crammed with a variety of amendments reflecting diverse legislative priorities, ranging from big to petty and cutting across all swaths of the political spectrum, in order to secure enough votes for passage.

Pruning Dodd-Frank. One of the "big" inclusions in the bill - that is creating something of a populist furor in the media - is an amendment that would scale back section 716 of the Dodd-Frank Wall Street Reform and Consumer Protection Act, commonly referred to as the "swaps push-out rule". Our favorite kemosabe, Senator Elizabeth Warren, is out proselytizing that scaling back the swaps push-out provision will allow "Wall Street to gamble with taxpayer money."

The swaps push-out rule. I suspect that you would rather poke pins in your own voodoo doll than read Section 716 of Dodd-Frank. Instead, we excerpt from one of many excellent legal summaries of the provision, this one from Cadwalader (edited for brevity):

One of the most contentious provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act1 (the “Dodd-Frank Act”) is Section 716 – commonly referred to either as the “Lincoln Amendment” after its principal proponent, Senator Blanche Lincoln of Arkansas, or alternatively by its functional name, the “swaps push-out rule.” The Lincoln Amendment effectively forbids FDIC-insured institutions and other entities that have access to Federal Reserve credit facilities – including banks, thrifts, and U.S. branches of foreign banks – from acting as a “swap dealer” except in certain limited circumstances, thus requiring such institutions to “push out” most swap dealing activities into an affiliate that is not FDIC insured and that does not otherwise access Federal Reserve credit facilities.

Inasmuch as maintenance of FDIC insurance is a requirement for all national banks, all federal thrifts, all state Member banks, and all (if not virtually all) state non-Member banks and state thrifts, Section 716 effectively precludes a bank or thrift from being a “swap dealer” after the effective date of the Lincoln Amendment.

There are some broad exemptions. Businesses and/or trading desks of the following swap products are exempt from the push-out rule:

• Interest rate and foreign currency swaps;
• Swaps involving bank eligible assets, such as agency MBS, marketable corporate grade debt, loans and precious metals;
• Swaps used in bank hedging activities and other risk mitigation.

So what swap businesses are actually prohibited at a bank under the rule? Generally speaking, banks are prohibited from engaging in swaps related to commodities, equities and credit (with a notable exception of investment-grade credit default swaps that are centrally cleared). These swaps businesses must be pushed out to a separately capitalized entity.

Why is the push-out rule controversial? You're going to love this, I promise.

1. Its inclusion in Dodd-Frank was opposed by virtually every banking regulator, the Treasury, and other financial regulatory bigwigs (see: Volcker, Paul) from the time it was initially proposed (in April of 2010). It didn't even have the support of the majority of Democrats. So, how did it get in the bill? 
2. It was put into the bill as a blatant and ultimately unsuccessful attempt to save Blanche Lincoln's (D-AK) senate seat. 

Let's address the regulatory resistance first. Excerpts from a Harvard Law School Forum post authored by lawyers at Davis Polk & Wardwell, titled Transition Period for Swaps Pushout Rule (edited for brevity, formatting added to improve the funny):

The Swaps Pushout Rule has been one of the most controversial provisions of the Dodd-Frank Act. It was opposed by the heads of all three federal banking agencies as well as Paul Volcker. Both Federal Reserve Chairman Ben Bernanke and former FDIC Chairman Sheila Bair said it would increase systemic risk, rather than reduce it. The Swaps Pushout Rule has not improved with age. Indeed, one of the key lessons from the preparation of resolution plans under Title I of the Dodd-Frank Act, and recent simulations of the resolution of a systemically important financial institution under Title II of the Dodd-Frank Act, is that pushing swaps out of insured banks into non-bank affiliates creates an impediment to the orderly resolution of banking groups.

When swaps are held within an insured bank, their value can be preserved for the benefit of the bank’s creditors (including the FDIC’s Deposit Insurance Fund) and the stability of the financial system because the FDIC has the statutory power and incentive to transfer the swaps to a creditworthy third party or bridge bank within one business day after the original bank’s failure, overriding any otherwise applicable rights of counterparties to terminate the swaps. In contrast, counterparties have the right to immediately terminate swaps held within a non-bank affiliate under the Bankruptcy Code, and bankruptcy courts have no power or incentive to override those rights by transferring the contracts to a creditworthy third party or bridge company. Selective termination of swaps by a bankrupt entity’s counterparties typically results in the sort of value destruction and severe market disruption that occurred in the Lehman bankruptcy. As a result, there have been numerous efforts since the enactment of the Swaps Pushout Rule in July 2010 to repeal or significantly modify it.

Editor's update: Sheila Bair has recently reversed her opinion and now thinks that the push-out rule should be kept in its entirety. You can read her opinions here. 

The Treasury also refused to endorse the push-out provision at the time, though current Treasury Secretary Jack Lew has stated that Congress should allow the SEC to finish the rulemaking process before it attempts to dismantle it. 

Swaps push-out as political pandering. It's tough to remember back to the spring of 2010. We were all running around with our financial hair on fire. Dodd-Frank was being constructed, Congressional voting was imminent, but no one knew for certain what was going to be included. Blanche Lincoln's proposal was one of several that was hotly debated in the press.

Excerpts from a May 15, 2010 article (in that notorious bastion of conservative journalism, the New York Times), In Tough Stance, Democrat Finds Few Allies (edited for brevity, formatting added):

The chairman of the Federal Reserve opposes it. The country’s chief banking regulator dislikes it. The secretary of the Treasury has been unsupportive, at best, and Paul A. Volcker — no one’s idea of a best friend to Wall Street — calls it unnecessary. 

Their antipathy is directed at a proposal from Senator Blanche Lincoln Democrat of Arkansas. She wants banks to get rid of their lucrative derivatives operations because they played an outsize role in the financial debacle. And when Wall Street needed a rescue, Mrs. Lincoln says, taxpayers should not have had to bail out bankers’ bad bets.

But just how far Democrats will pull back from an outright prohibition is unclear. Mrs. Lincoln is in a vicious primary campaign. Her opponent has tried to portray her as a Washington insider cozy with Wall Street and big business. If Mrs. Lincoln is seen as having given ground to bankers on derivatives, she could lose her job — and Democrats might well lose the seat to a Republican this fall.

In the month since Mrs. Lincoln offered her proposal, Democrats have played a waiting game. But in that time, opposition has grown and bank lobbyists have fought her plan, what they call the “push out” provision. 

Banks are betting that with the support of the prominent regulators, Democrats will have the political cover to oppose Mrs. Lincoln’s provision without appearing to give in to Wall Street. 

Mrs. Lincoln is adamant in her belief that banks should not be in the business. 

“Banks were never intended to perform these activities, which have been the single largest factor to these institutions growing so large that taxpayers had no choice but to bail them out in order to prevent total economic ruin,” she said this month. 

Editor's aside: I am tempted to parse the sentence above and refute the allegations in it as factually incorrect, misleading, and resorting to the usual chicken-little style hyperbole of politicians, but (a) the argument was 4+ years ago; and (b) she lost the general election in 2010 in a landslide.

The nation’s chief banker disagrees. In a letter last week to several senators, Ben S. Bernanke, chairman of the Federal Reserve, said that “forcing these activities out of insured depository institutions would weaken both financial stability and strong prudential regulation of derivative activities.” 

 Below is an arbitrary calendar of events, after the above article appeared in the New York Times on May 15, 2010.

• Arkansas Democratic primary, May 18, 2010: US Senator Blanche Lincoln (Democrat) 44.5%, Lieutenant Governor  Bill Halter (Democrat) 42.5%, DC Morrison  (Democrat)12.3%

• Arkansas Democratic primary run-off, June 8, 2010: Blanche Lincoln 52%, Bill Halter 48%.

• Dodd-Frank legislative text finalized, June 25, 2010: The Senate-House conference agrees on final legislative text of the Dodd-Frank bill, including Section 716, the "swap push-out provision" as proposed by Blanche Lincoln. 

• General election, November 2, 2010: John Boozman (Republican) 57.9%, Blanche Lincoln 36.9%

Tailoring the swaps push-out rule in CRomnibus. This is actually pretty straightforward. The House is proposing to shrink the swaps push-out rule so it will not apply to equity and commodity swaps. Airlines that want to hedge their jet fuel exposure can do so at reasonable cost at any bank with a relevant swaps desk. So what is still pushed out? From a House of Representatives write-up:

The section would continue to apply to structured finance swaps that are based on an asset-backed security. Retaining coverage of structured finance swaps based on asset-backed securities was intended to address concerns surrounding the well-known derivatives activity of American International Group (AIG) based on mortgage-backed securities which directly contributed to the company's precipitous decline and Federal bailout in the fall of 2008. 

For the record: AIG? NOT A BANK. Problem with their "security based structured finance swaps"? They were based on subprime mortgage securities. It was never the "swaps" at "banks" that were the problem; it was that the underlying collateral was bursting into flames. Congress should have listened to the regulators, because they were right. (I know, I can't believe I said it either.)

We're done here.