Taxpayers could be liable again for bank blunders
With the House and Senate having passed a bill to avoid a government shutdown, the country is one step closer to avoiding a government shutdown -- at least for the next fiscal year that ends in September 2015. Now it just requires signature by President Obama to become law.
According to critics, however, the bill also brings the country closer to another potential financial crisis by removing a key provision of the Dodd-Frank financial regulation law. By doing so, Congress may have opened the door to banks using depositor insurance, intended to protect consumers, to cover losses from bad bets on certain esoteric and risky investments.
Some Democrats, like Massachusetts Senator Elizabeth Warren, lobbied against passage of the spending bill with the measure to soften financial regulation.
The Dodd-Frank modification is "so clearly written by the banks," said Mike Konczal, a fellow with the Roosevelt Institute, in an interview with CBS MoneyWatch. "You can read the changes, and they read like what Citigroup wanted [in 2013]."
Esoteric investments
The Dodd-Frank section in question is 716, and it prevented banks from directly investing in certain types of derivatives -- financial instruments that are essentially legalized bets on how other financial transactions or products will perform. An example that helped bring on the Great Recession just a few years ago was the so-called collateralized debt obligation, or CDO.
An investment bank would gather together a certain type of asset, like subprime mortgages, and then create what was essentially a bond backed by those assets. Investors would buy shares, paying a fixed amount up front. In return, they were supposed to get regular payments, including a specific amount of interest.
But when homeowners across the country defaulted, the quality of the mortgages came into question and it was clear that many of the mortgage-backed CDOs weren't bringing in enough money to pay the investors. As more of them collapsed, they threatened the stability of major banks and, therefore, the entire financial system.
Other types of derivatives can be based on many other financial transactions, like the credit default swap, essentially a form of insurance that one party buys to ensure it will receive all the fixed payments from a third party, like a bond issuer, it expects.
Some of these derivatives are traded on exchanges, so it's possible for everyone to see the rates they bring, how often the arrangements fall apart and other information that's crucial to informed investment and risk management. Some are not, and they can be risky under the right circumstances. Credit default swaps were the instruments that forced insurer AIG to collapse and ultimately need a massive rescue from the federal government.
Passing on the risk
Section 716 of Dodd-Frank has prevented banks from directly speculating in the riskiest and least transparent derivatives. Instead, they have had to create separate companies that have their own capital to invest. That effectively built a firewall that protected ordinary deposits.
If the spending bill would eliminate 716, it would allow banks to trade the more exotic derivatives within their regular business structures. The potential problem is that the capital they use involves accountholders' deposit. If a bank lost enough money on a series of bad bets, as did AIG or Lehman Brothers, it could run out of capital and require a federal bailout, critics say. The federal government, through insurance programs like the Federal Deposit Insurance Corp., would be on the hook for the lost amounts.
"It's also like a psychological firewall," Konczal said. "These are things we should not do inside the traditional banking structure."
Bank lobbyists are expected to pursue further changes to Dodd-Frank once Republicans gain control of Congress in January. But the law is unlikely to be overturned in the short-term given broad Democratic support of Dodd-Frank and the likelihood that President Obama would block such an effort.