Senate Agriculture Committee Chair Blanche Lincoln's (D-AR) aggressive derivatives bill passed committee yesterday and now awaits its merger with the chamber's broader financial reform bill. It contains a controversial measure which would forbid the use of federal funds to assist any financial institution on the brink of collapse due to derivatives gone bad. While this will probably have a great deal of populist appeal, it appears to be in direct conflict with both versions of financial reform floating around Congress and general market stabilization efforts.

Ties Regulators Hands in Some Financial Crises

Both the House and Senate bills call for resolution funds that regulators would use to wind down large financial firms. Those funds would cover the costs incurred during that process, so that taxpayers wouldn't be on the hook for another bail out. The FDIC would be in charge of that fund, yet the derivatives bill specifically forbids the FDIC from using its power to go towards the obligations of institutions that run into trouble due to derivatives. Isn't it conceivable, however, that money due to derivative counterparties is precisely the kind of cost these funds might need to be used for? If the end is to stabilize a financial panic, then calming the market could depend on alleviating the fear of a catastrophic domino of swap dealer failures.

The bill also forbids the Federal Reserve from using its emergency lending authority to provide a loan to a firm that might be in trouble due to derivatives. Again, this means that the Fed won't be able to exercise its authority to stabilize the financial markets if a derivatives-related disturbance causes instability.

Think AIG

Perhaps the prototypical example of a big systemically intertwined firm that ran into trouble due to derivatives is AIG. A large portion of its bailout funds were famously used to cover some of its derivatives (swaps) obligations to big investment banks like Goldman Sachs and Societe Generale. This new legislation would make that bail out impossible.

While that might sound great to populists everywhere, how would the U.S. government have stabilized the financial system if this legislation were in place prior to the financial crisis? Remember, even to wind down AIG, costs would have surfaced that needed to be addressed in order to prevent the market's collapse. The proposed resolution fund created by assessments on big financial institutions might have covered such costs instead of taxpayers, but it wouldn't be able to be used according to this legislation.

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