Senate Majority Leader Harry Reid and Banking Committee Chairman Chris Dodd were all smiles after the Senate passed its financial reform bill on Thursday. (epa/ZUMApress.com)

This afternoon, the U.S. Senate passed a sweeping financial regulatory reform bill, overhauling the regulation of everything from the biggest banks to consumer financial products to exotic instruments like credit-default swaps to the derivatives used by farmers. The bill passed 60 to 39.

[Congress1] Earlier on Thursday, Republicans Olympia Snowe (Maine), Susan Collins (Maine) and Scott Brown (Mass.) voted for cloture to end debate and move on to the final majority-rules vote. The bill just made the cloture mark, with 60 votes. Sen. Russ Feingold (D-Wis.) chose not to vote with his party, saying he did not find the bill strong enough. White House spokesman Robert Gibbs that President Obama will probably sign the legislation into law next week.

Thus ends a yearlong saga for the bill, whose architects Rep. Barney Frank (D-Mass.) and Sen. Chris Dodd (D-Conn.) spent hundreds of hours in negotiations before coming up with the final package. Work on writing the bills started last summer in the House and the Senate. The House approved its version of reform in December, and the Senate passed its version in May.

The biggest sticking point for reform in the Senate — and one of the reasons the bill took longer than in the House — concerned derivatives, which allow an investor to hedge against price fluctuations in a stock, commodity or other product. The derivatives portion of the bill fell under the purview of the Senate Agriculture Committee, headed by Sen. Blanche Lincoln (D-Ark.). Facing a tough primary challenge from the left, Lincoln inserted a strong provision forcing banks to spin off their trading desks for swaps — a kind of derivative — and to capitalize them separately. Companies vehemently fought against the proposal, but it ultimately appeared, albeit in a slightly changed form, in the final bill.

Once the House and Senate had their bills, the two moved to a conference committee to iron out their differences. In conference committee, the Senate bill was used as the base text, while Dodd led a team of more than 40 legislators voting on various changes. Dodd, Frank and the other conferees addressed everything from regulating derivatives to limiting banks’ ability to bet their own money alongside their clients’. Conference committee culminated in a 20-hour marathon session in June. The combined bill then passed the House again — and today it cleared its last hurdle in the Senate, sending it to the president’s desk.

The final bill, more than 2,300 pages in length, directs regulators to create 533 rules, according to the Chamber of Commerce. The bill contains three central provisions. First, it provides the government with new powers to identify risky banking institutions and to shutter them before they harm the broader financial system, via a new systemic regulator. Henry Paulson, the Treasury Secretary under President Bush when the financial crisis first hit, lauded the provision this week. “We would have loved to have something like this for Lehman Brothers. There’s no doubt about it,” he told The New York Times, referring to the investment bank that collapsed, destabilizing the country’s financial system and contributing to the credit crunch. Democrats say this provision ends “too big to fail,” by providing the government with a way of shutting down failing banks, reassuring counterparties and containing any sense of panic.

Second, the Dodd-Frank bill makes banks less dangerous, forcing them to keep more capital on hand, banning them from making risky trades on their own behalf and keeping them from investing heavily in vehicles like hedge funds. “[The bill] places some limits on the size of banks and the kinds of risks that banking institutions can take,” President Obama told an audience of Wall Street workers this spring, speaking at Cooper Union in Manhattan. “This will not only safeguard our system against crises, this will also make our system stronger and more competitive by instilling confidence here at home and across the globe. Markets depend on that confidence. By enacting these reforms, we’ll help ensure that our financial system — and our economy — continues to be the envy of the world.”

Finally, it creates a new consumer financial protection bureau, which will have the power to create and enforce new rules regarding financial products like home-equity loans and credit cards. “Consumers finally will have a cop on the beat … that will monitor the market and write and enforce the rules,” said Susan Weinstock, the financial reform campaign director for the Consumer Federation of America. “The Wild West for financial products and services is coming to an end. Consumers will now have a bureau that will clear out the tricks and traps in financial products and services that have harmed so many Americans.”

That said, the bill is imperfect by anyone’s measure. It orders 68 studies, and leaves major decisions up to regulators prone to lobbying and industry influence. It includes loopholes, including the glaring exemption of auto dealers who make car loans. But a broad range of experts on Wall Street, consumer protection and governance have lauded it as the strongest reform made since the Great Depression.

“This isn’t just about dollars and cents,” Sen. Harry Reid (D-Nev.), the majority leader, said on the floor. “It’s about fairness and justice. It’s about making sure there’s not a next time. It’s about jobs. And it’s about rescuing our economy.”

Correction: Sen. Scott Brown was initially incorrectly listed as being from Maine. Thanks to commenter Flitedocnm for pointing out that Maine cannot in fact have three sitting senators.

Ending “too big to fail” also requires building stronger shock absorbers throughout the system so it can better withstand the next financial storm. To do that, the Senate bill closes loopholes and opportunities for arbitrage, and it brings key markets, such as those for derivatives, out of the shadows. Transparency will lower costs for users of derivatives, such as industrial or agriculture companies, allowing them to more effectively manage their risk. It will enable regulators to more effectively monitor risks of all significant derivatives players and financial institutions, and prevent fraud, manipulation and abuse. And by bringing standardized derivatives into central clearing houses and trading facilities, the Senate bill would reduce the risk that the derivatives market will again threaten the entire financial system.

Sen. Judd Gregg (R-N.H.) had a detailed opinion piece in Bloomberg on the same topic:

Congress’s aim for OTC regulation is to reduce systemic risk to the financial system by, at the very least, providing an efficient regulatory structure that reduces the frequency and severity of market liquidity problems.

By and large, the swaps market is a wholesale, institutional market where most trades are large, block-sized transactions. Mandatory exchange trading would reduce market liquidity and increase execution costs for the ultimate end-user of these swaps. Advocates for mandated exchange trading want to decrease bid-ask spreads, which would theoretically lower the cost of these products, but they fail to understand the market sensitivities.

Mandating real-time dissemination of swap transaction price and quote data will require market participants to announce their trading interests to the entire market and allow others to step in front of their trades, moving the market against their hedges. In such an environment, market liquidity for swap transactions will decrease dramatically, if not disappear altogether.

To unpack: Geithner and Gregg sound like they might be at (incomprehensible) loggerheads, but they are not actually saying very different things. Geithner wants to exchange-trade derivatives, making pricing and volume information open to the market. Gregg argues that if pricing and volume information are public, the market will react to that information, making certain trades more expensive or even impossible. Both agree that exchange-trading derivatives will reduce fees for Wall Street banks and provide transparency into the true cost of swaps and other financial instruments.

There is a backdrop to the two wonky op-eds: Derivatives are the newest battleground between Democrats and Republicans, reformers and Wall Street. The Obama administration is currently pressuring the Senate Agricultural Committee (which is writing the derivatives part of the legislation) to ensure that the rules aren’t so loose as to exempt many financial firms and non-banks from using the exchanges.

Reuters had asked Schapiro whether there should be any ban or limits placed on naked swaps, where the holder of the swap does not own the underlying bond.In reply, Schapiro said credit default swaps are often used as substitutes for securities and directly impact the markets.

“As such, they should have at least the level of oversight and transparency that are present in the regulated securities markets,” she said.

Her statements echoed those of Commodities Futures Trading Commission Gary Gensler, who said earlier today that the lack of regulation in derivatives trading allows Wall Street to benefit from market inefficiencies (i.e., that they profit off of investors who they deliberately keep in the dark) rather than from underlying value. Not that it matters to the financial services industry: Money is money, whether it comes from less-than-savvy investors or Treasury coffers.

Martin Mayer predicted all of that in his book “The Danger of Derivatives” in 1999, and in an interview with Gretchen Morgenson of The New York Times, he offers some solutions the government could — but probably won’t — put into effect to stop a repeat of this crisis.

To prevent the regular insurance industry from taking customers’ premiums and then being unable to pay out claims, the industry is regulated. The states and federal government require that insurance companies keep significant capital around so that if there are a number of simultaneous claims, they can be paid without bankrupting the company. Insurance giants like AIG liked derivatives because it allowed them, for a time, to make money without having to comply with the capital requirements of regular insurance.

The banks that use derivatives like them, too, as they are able to take risky bets without assuming all of the risk. And, as Mayer points out, in the wake of the bailout, they continue to make risky investments, now that they know full well the government (and taxpayers, by proxy) won’t allow them to fail. Mayer recommends that derivatives be regulated like the insurance products they are and traded on the open market because it requires more transparency in terms of accounting and risk, and that taxpayer-insured banks (i.e., commercial bans) be barred from using them because of the risk.

Of course, Mayer doesn’t believe that will happen, in no small part because too many in Congress don’t understand derivatives and are more than happy to allow financial industry lobbyists to argue that they aren’t really insurance and aren’t really that risky, and that to regulate them will mean stifling innovation. Of course, this “innovation” is simply a way to insure some and then make money off of the failure of others — quite the innovation.

But the financial industry ought to be happy that Mayer is just calling for oversight and regulation — Financial Times columnist Wolfgang Munchau called this weekend for an outright ban on credit default swaps, and he’s hardly the first. They might end up stuck between the proverbial rock and hard place — but without the sweet lubrication of taxpayer dollars to bail them out again.

Nevertheless, even the new Greek government, which is breaking with many of the traditions of its predecessors, cannot manage without the US investment bank. Goldman Sachs and Deutsche Bank were among the six banks that placed Greek government bonds worth €8 billion in early February. Perhaps the Greeks were trying to remain on good terms with the two powerful banks. Both were among the most active traders in CDSs, which are often traded on behalf of hedge funds.

Speculation or not, it brings up an interesting point: When the banks interested in making money off of government contracts could benefit equally by betting against a government’s solvency — especially if they don’t get those contracts — their potential influence over governments can only get out of control.

Cantor’s product would allow movie makers and theaters to offset their risks on a project by buying or selling legal bets on a given movie’s take during the first four weeks it is in box offices. Like investors in credit default swaps — who bet that Americans with subprime mortgages would default — movie derivative investors could bet on the success or failure of a given movie. And unlike with credit default swaps, some of the people making bets on movies could be the very people with the decision-making power to help or hurt a given movie’s chance of success.

Economists say that derivatives aren’t supposed to be just legalized gambling, and that Cantor’s movie derivatives are little better than the average sports book.

In that context, Cantor’s plan could be “incredibly dangerous,” [UCLA professor Lynn] Stout says. “Until we fix this legal problem that you can make purely speculative derivative bets, we have to worry that any newly created form of derivative can add risk to the system.”

But with companies like Cantor Fitzgerald lining up to oppose financial sector reforms and the creation of a consumer protection agency for financial services products, we may have to keep worrying.

But unless you’re well-versed in the modern minutiae of the financial market, it probably didn’t help explain anything about why Treasury Secretary Tim Geithner is facing an investigation into his role in the affair.To recap Morgenson and Story:

• The people at Goldman Sachs invested in mortgage-backed securities they expected to decline in value in order to make money off the insurance claims.
• Due to a long-standing relationship, they went to AIG for a kind of insurance — credit default swaps — which were not regulated.
• They then used other companies, including Société Générale, to purchase more of the unregulated insurance that AIG might not have otherwise underwritten in order to manage its own risk.
• When Goldman’s investments declined, they submitted insurance claims for the losses, but insisted on determining the amount of their damages on their own, without any input from AIG, any auditor or the market.
• After Goldman got as much money out of AIG as they thought they could, their stock analysts issued a report about how AIG was bleeding cash and their creditors wouldn’t negotiate, without mentioning that AIG was bleeding cash because of them and that Goldman was the creditor that wouldn’t negotiate. AIG’s stock tanked.
• The government stepped in, took an 80 percent share in AIG and then paid Goldman and the other creditors all the money they’d asked AIG for at the start of the negotiations in 2007, without using their power to force AIG’s creditors to negotiate.

When the federal government, including then-Treasury Secretary Hank Paulson (who once served as chairman and CEO of Goldman Sachs), directed AIG to pay Goldman exactly what it wanted, it overrode significant and long-standing misgivings by AIG’s lawyers and accountants that Goldman’s estimates of its losses were correct. Morgenson and Story note that the prices on the very securities for which Goldman demanded insurance payments have since rebounded — but under the terms of the deal struck by the federal government, Goldman doesn’t have to pay a cent of its insurance settlement back to either AIG or the taxpayers. That’s quite the sweetheart deal for Goldman Sachs, if not taxpayers.

Now-Treasury Secretary Tim Geithner’s role in the November payouts is under investigation; his spokesperson said last month that then-New York Fed Chair Geithner officially recused himself from participating in the AIG bailout after Nov. 24, 2008 — the date of his nomination to Treasury — and had begun to insulate himself from such decisions “weeks earlier in anticipation of his nomination.” The Presidential election was held Nov. 4, 2008, and the plan to give Goldman everything it wanted was made official 6 days later, on Nov. 10. Either Geithner was insulating himself from his own job weeks before the election, or he was as involved in the negotiations as his detractors have charged.

Documents have recently emerged showing that the N.Y. Fed, starting as early as Geithner’s Treasury nomination announcement, worked with AIG to prevent full disclosure of how the bailout money it received in November went straight to companies like Goldman Sachs, Société Générale and Deutsche Bank, among others. The order to AIG from the government not to negotiate with its creditors may have cost U.S. taxpayers $13 billion; it was only under pressure from the SEC that AIG made public in March 2009 (after Geithner’s confirmation) the banks to which it had transferred its bailout funds.

As the N.Y. Fed staffers — who, despite his recusal, still worked for Geithner — were pressuring AIG to refrain from disclosing the government’s demands on behalf of Goldman and the secondhand amount Goldman received from the bailout, Geithner was amending his tax returns and paying back taxes in order to survive his confirmation process. Revelations that he’d also used his position at the N.Y. Fed to preserve the financial interests of Goldman Sachs over taxpayers or the company in which the government had taken a majority stake might have scuttled his nomination entirely. These days, many Democrats seemingly think that perhaps it should have.

That’s why a new documentary “American Casino,” by famous filmmakers Andrew and Leslie Cockburn, is already getting attention. In it, a former banker from Bear Stearns, is filmed, with his identity concealed, elaborating on Wall Street’s role in packaging and selling subprime loans, and admitting that the financial world knew the whole thing was a big scam all along.

But think about that for a moment. The former banker insisted on being filmed in shadow, to feel free enough to talk about Wall Street’s role in the crisis. How telling is that? On Wall Street, apparently, you have to hide in anonymity to tell the truth about the mortgage market meltdown.

Here’s David Denby in The New Yorker, describing the former banker’s turn on the screen:

We might be watching a retired criminal or spy, a man both proud of his dexterity and ashamed of the disaster that it led to. Out of the shadows, he explains how such bizarre instruments as collateralized debt obligations (C.D.O.s) quieted the normal skepticism of investors. Here’s the drill: when the bank assembled a group of mortgage-backed bonds as an investment product, it submitted them to a ratings agency. But the agency, rather than run its own computer models on the trustworthiness of such bonds, he says, merely handed the job back to the bank, which ran its models. Having received a fee of perhaps a hundred thousand dollars for not doing anything, the agency then signed off on the phony ratings. You can read about a scam like that in a newspaper and be surprised, but when the perpetrator actually explains it to you your reaction falls somewhere between nausea and hilarity. It’s as if the Russian Mafia had paid a Colombian drug cartel to certify its integrity.

At the Wall Street Journal’s Speakeasy blog, the Cockburns were asked whether they thought any of the financial executives they talked to for the film were contrite.

I think that when some of them came to the film, they were very thoughtful about the link between what they were doing and what was actually happening.  It’s a very enclosed world on Wall Street. As one of the execs says, if we’d all gotten in a car and seen for ourselves what was going on Florida, or California, or wherever, we might have viewed things differently.

That’s an especially interesting comment, given that the aftermath of the foreclosure crisis in some cities is shaping up to be as bad, or worse, than the foreclosures themselves, with trashed and vandalized bank-owned foreclosures piling up. Now would be a good time for Wall Street to take a road trip into the rest of the country. And policymakers in Washington should probably go along.

Sens. Carl Levin (D-Mich.) and Susan Collins (R-Maine) introduced legislation today authorizing federal regulators to oversee the credit default swaps market — which has ballooned into a $57 trillion industry.

You remember credit default swaps. These babies — in essence, private insurance contracts in which one institution pays another when a third party defaults — are used to spread financial risk. They’re just one branch of the enormous swaps market. Yet the over-leveraging they allowed are thought by many experts to be among the primary factors leading to the global economic meltdown.

You might think that, considering the sheer size of the market, federal regulators would have been examining these swaps beneath a microscope. Think again. Current federal law actually prohibits the federal government from overseeing swaps at all.

Levin, who chairs the Senate Homeland Security and Governmental Affairs investigative subcommittee, and Collins, who also sits on the panel, are hoping to change that. Their proposal would remove the regulatory prohibitions on swaps while authorizing — though not requiring — the federal government to regulate the various swaps markets.

From Collin’s statement:

While local credit unions and small community banks are subject to safety-and-soundness regulation, enormous Wall Street financial institutions that have a far greater impact on our economy have not been subject to such regulation. This legislation would clear the way for federal financial regulators to oversee the swaps market. It is a critical component of the overall reform needed to restore confidence in our financial regulatory system.

The statement also lends a sense of just how huge the swaps markets have become:

Swaps are typically an agreement between two parties placing a bet on future cash flows. Some swaps bet on whether a stock price, interest rate, commodity price, or currency value will rise or fall; others bet on whether a company will default on payment of a bond. Stock price bets are referred to as equity swaps; bets on whether companies will pay their debts are referred to as credit default swaps.

According to the latest data compiled by the Bank of International Settlements, as of June 2008, worldwide swaps markets included credit default swaps with a total notional value of $57 trillion; commodity swaps with a notional value of $13 trillion; equity swaps with a notional value of $10 trillion; foreign currency swaps with a notional value of $62 trillion; and interest rate swaps with a notional value of $458 trillion.

The real question is, with so much at stake, why regulators have been banned from monitoring these transactions to begin with.

That’s not great news for the embattled Dodd, who is fighting for his political life in the face of a 33 percent approval rating and a 2010 reelection challenge from former Rep. Rob Simmons (R-Conn.). But even if the five-term senator doesn’t have too many fans in Connecticut, they love him at Intercontinental Exchange, one of the nation’s leading exchanges trading credit default swaps and other risky financial instruments.

Executives at Intercontinental (known as ICE) donated $18,400 to Dodd’s reelection campaign during the first quarter of this year, according to the senator’s report to the Federal Election Commission this week.

That’s more than four times the amount that Connecticut residents contributed to Dodd.

And ICE has good reason to cultivate a friendship with the Banking Committee chief. The company was recently approved by government regulators to begin “clearing” trades of derivatives, the risky financial instruments that helped take down AIG and were estimated last year to exceed the real value of the whole world’s financial holdings. ICE now has an interest in ensuring that derivatives trading remains supervised by a small group of firms, thus maximizing its ability to profit from the market.

But ICE isn’t the only company outdoing Connecticut natives in generosity to Dodd. Six employees of the lobbying firm Patton Boggs gave the senator’s campaign $5,500 on a single day during the first quarter, and employees of the financial services company Chesterfield pitched in $6,900.

So Dodd has an impressive number of supporters … just not that many who can vote for him next year.

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