That’s not all. At Naked Capitalism, guest poster George Washington says the financial industry lobbyists aren’t just trying to kill new laws – they’re actually trying to weaken existing regulations, citing Robert Borosage’s similar argument.

And this is only after the first day of the committee’s hearings.

Good to see how much President Obama has changed the culture of Washington.

A little background: After the Great Depression, a Congressional panel called the Pecora Commission investigated Wall Street’s misdeeds and set the stage for financial regulations that lasted for decades. Since the current meltdown, some have been calling for another commission. That seemed unlikely at first, because Congress itself undid many of the regulations the Pecora Commission created — and it appeared unlikely lawmakers would choose to investigate themselves.

But that view has turned out to be overly skeptical. Reuters reported recently that Congress in on the verge of naming members to a bipartisan panel known as the Financial Crisis Inquiry Commission, based on the Pecora model. While that should be welcome news, some of the names emerging as possible panel members are already causing consternation.

From Reuters columnist Matthew Goldstein:

But there are already worrying signs that this commission will lack the political nerve to tackle the tough issues, let alone ask the right questions. Reuters reported last week that some of the people being considered for the commission include many former Congressmen, governors and familiar talking heads from Washington think tanks. Let’s hope that will not be the case because the financial system can’t truly be fixed until there’s a candid assessment of who let things get so out of control.

Sure, put some wise political statesmen on the commission. But also allow room for some longtime Wall Street critics, derivatives traders and hedge fund managers — the kind of people who know the system from the inside out.

Appearing before hundreds of business officials in Washington, Larry Summers said the finance industry has evolved both enormously and unpredictably since he urged those changes as Treasury secretary for President Clinton in 1999.

“I think the world has changed in very profound ways since the 1990s,” Summers said.

In November 1999, Congress passed the most sweeping changes to the finance industry since World War II. The bill, known as the Gramm-Leach-Bliley Act, repealed part of the 1933 Glass-Steagall Act, in effect blurring the boundaries between commercial banks, investment banks, insurance companies and securities firms.

At the time, Summers was a leading cheerleader for the bill, applauding its passage in no uncertain terms. ”Today Congress voted to update the rules that have governed financial services since the Great Depression and replace them with a system for the 21st century,” he said at the time, according to The New York Times. ”This historic legislation will better enable American companies to compete in the new economy.”

Others weren’t so sure. Sen. Byron Dorgan (D-N.D.) said after the vote that “we will look back in 10 years’ time and say we should not have done this,” while the late Sen. Paul Wellstone (D-Minn.) warned that lawmakers ‘’seemed determined to unlearn the lessons from our past mistakes.”

No matter. The bill passed the upper chamber by a vote of 90 to 8, and Clinton signed it into law shortly thereafter.

A decade later, many of the nation’s top economists say the current recession is largely a consequence of that law, which freed commercial banks to dabble in more risky investments, like mortgage-backed securities, while empowering the largely unregulated non-banks (think: AIG) to get into the mortgage lending business.

Summers said Thursday that that was a different era — a time when credit default swaps “were a blip” and “very few people” predicted either their meteoric rise or the degree to which an overexposure to those complex products could harm the larger economy. In the finance environment of the late 1990s, he said, the deregulations made perfect sense — just as they wouldn’t make sense today.

“You have to think about how the different parts interact,” Summers said. “That’s how you get to the best possible policies.”

And it’s all far worse than you might think.

Sorkin offers an answer to a question I’ve been asking for a while: Who wants to hire those supposed AIG financial geniuses? They brought one of the world’s largest insurance firms to its knees and put the entire economy at risk.

Well, guess who does want them — and apparently is even fighting for their services?

It’s the companies that want to bet on AIG’s demise, using the expertise of the former employees who put together its house of cards in the first place. From Sorkin:

A.I.G. built this bomb, and it may be the only outfit that really knows how to defuse it.

A.I.G. employees concocted complex derivatives that then wormed their way through the global financial system. If they leave — the buzz on Wall Street is that some have, and more are ready to — they might simply turn around and trade against A.I.G.’s book. Why not? They know how bad it is. They built it.

So as unpalatable as it seems, taxpayers need to keep some of these brainiacs in their seats, if only to prevent them from turning against the company. In the end, we may actually be better off if they can figure out how to unwind these tricky investments.

Let’s see if I understand this: We have to pay to keep in place the people who put together ruinous financial deals, only because they are the only ones who understand how to unwind them – and they’ll take that information and use it against their former company, and American taxpayers, if they don’t get their millions in bonuses.

This goes far beyond the pale. If the government can’t act because of the sanctity of compensation contracts — I still don’t fully buy this explanation, but that’s for another day — there are still things the rest of us can do.

Let the sun shine in. Fire up the FOIA requests. Support New York Attorney General Andrew Cuomo as he goes after the names of those getting the bonuses. I talked about this on Monday — let the friends and neighbors of those holding AIG and the American taxpayers hostage with their bonus demands know exactly who they are.

I guess Wall Street must have operated this way for years — take what you can for yourself, screw over the company you left behind, get a pat on the back for your cleverness — but things are different now. We’re in a crisis that is increasingly draining away public funds that could go to other uses, and we all have the right to know what’s going on with our money, and who is benefiting from it — especially for personal gain rather than the public good.  And if it’s true that AIG employees want to go elsewhere and use their knowledge to tank the company if they don’t get their money, then let them stand up and admit it. I’m not talking about vigilantism. Just the more powerful weapon of public shame, like what happened in Houston after Enron fell. Maybe it won’t be so socially acceptable to strut your ability to rip off your former employer and your country anymore.

And going forward, the Obama administration must put a stop to this. Non-compete clauses are common in the corporate world. Take a bonus from AIG in its inevitable next round of bailout funds, and sign on the dotted line that if you leave the company you won’t use your knowledge to work for its demise. AIG financial products employees should probably sign such a clause regardless of whether they receive a bonus, because it’s the right thing to do.

If anything good comes out of this financial crisis, maybe it will be the return of shame. Don’t count on it, though. Wall Street’s probably already gearing up to fight off financial reform. We should be smarter about this, moving forward. Follow the money that gets spent by the financial industry to fend off new rules and regulations.  Stop letting firms that taxpayers are keeping afloat make all the decisions behind closed doors. Make compensation and bonuses an open book. The lesson from this AIG mess isn’t just about derivatives and credit default swps. It’s much simpler: Don’t allow the public to get blindsided again.

Mr. Obama called A.I.G. “a corporation that finds itself in financial distress due to recklessness and greed.”

“Under these circumstances, it’s hard to understand how derivative traders at A.I.G. warranted any bonuses at all, much less $165 million in extra pay,” Mr. Obama said. “How do they justify this outrage to the taxpayers who are keeping the company afloat?”

White House officials said that the administration is not looking to take A.I.G. to court to stop the company from paying out the bonuses. But they said the Treasury Department would be trying to figure out what they can do to block A.I.G. from making the payments within the legal confines of A.I.G.’s contractual obligations to the executives.

I’m not really sure how that last strategy may work. As Hilzoy points out, those AIG derivatives experts may have tied everyone’s hands. It may be that only the people who put credit default swap agreements together know how to unwind them. If so, demanding bonuses could be a form of blackmail. From Hilzoy:

If I ran someone down in a car on a deserted road, it would take a lot of gall for me to ask him to pay me an exorbitant price to take him to the hospital since there’s no other car around. When you run someone down, taking him to the hospital is the least you can do, and payment shouldn’t so much as enter the picture.

Likewise, when you run the world financial system and the American taxpayer down, it takes a lot of gall to ask for not just a performance bonus, but a retention bonus as well. Any remotely decent person would stay and try to unwind the damage s/he had caused, if s/he was the only person who could do so, and would be content with his or her salary. (After all, it’s not as though people in financial services are generally underpaid.)

If the people in the AIG Financial Products felt this way, they could have made all these legal issues about contracts vanish by simply declining their bonuses. And they could solve the retention problem by agreeing to stay around as long as they’re needed, at their existing salaries. Instead, they are using our predicament to extract even more money for themselves. And that’s obscene.

Maybe we should begin listing the identities of the AIG financial products employees who accept the bonuses. If they can’t hide their actions — and  their friends and neighbors come to know exactly what kind of people they really are — maybe some of this nonsense will end.

New York Stock Exchange (Flickr: ralphunden)

As Congress mulls how to buoy a sinking economy, lawmakers seem increasingly determined to rein in the unregulated derivatives industry, which many suspect has caused much of the mess.

During two congressional panels convened this week, key lawmakers have vowed to push new regulations for the derivatives market, with a particular focus on complex instruments called credit default swaps, or CDS.

Those swaps — effectively private insurance contracts in which one party pays another when a third party defaults — are used by banks and other financial institutions to spread risk. Unlike insurance contracts, however, no one in Washington is charged with overseeing them. The practice has left trillions of dollars in exposed debts — including mortgage-backed securities — in the hands of the same firms that are flailing under the current economic crisis.

Illustration by: Matt Mahurin

The lack of oversight, combined with the sheer complexity of the layered transactions, has left lawmakers convinced that new protections are needed, but unsure what form they should take. The agriculture committees in both the House and Senate took up the issue this week, because past deregulations of CDS had fallen under their jurisdiction.

“There is an estimated $55 trillion in credit default swaps somewhere out there,” Rep. Collin Peterson (D-Minn.), chairman of the House Agriculture Committee, said Wednesday, “but no one knows for sure if any of these swaps offset each other, exactly who is on the hook for these swaps, who is trading with who and on what terms. And worst of all, no one has any idea who is solvent and who is upside down.”

These comments emerge in the middle of an economic downturn that’s already caused Washington to intervene in the finance industry in ways not seen since the Great Depression. On Tuesday, the Bush administration officially announced a partial nationalization of the banking industry, pledging to invest as much as $250 billion directly in the nation’s largest financial institutions before the end of the year. Word of the plan sent stocks soaring on Monday. Yet on Wednesday, news of slow consumer spending sent the Dow Jones Industrial Average plunging more than 700 points.

In the face of the downturn, both Congress and the White House are scrambling to search for possible remedies. Regulating the CDS market has been increasingly floated as one such reform.

On Wednesday, some administration officials joined Peterson and other House lawmakers in calling for a system allowing “clearinghouses” to scoop up the CDS, thereby mitigating risk among the participants in CDS contracts. All are hoping this might help thaw out the frozen credit market. There is growing debate about how many clearing entities would be created, and whether they would fall under the jurisdiction of the Commodity Futures Trading Commission or the Federal Reserve.

“Clearinghouses ensure that every buyer has a guaranteed seller and every seller has a guaranteed buyer,” said Walter Lukken, acting chairman of the Commodity Futures Trading Commission. “No U.S. futures clearinghouse has ever defaulted on its guarantee.”

The rise of CDS as tools of the finance industry has been meteroric. Lukken said the global notional (or face) value of CDS has doubled each year this decade. In 2007, according to the Bank for International Settlements, that value was roughly $58 trillion — close to the gross domestic product of the entire world.

There’s good reason for that skyrocketing popularity. First, CDS can be traded, or swapped, by large financial firms more easily than insurance policies can. And second, the buyer doesn’t have to prove it can cover the risk if the deal goes south.

The swaps were used by financial institutions to back their obligations — including mortgage-backed securities — in order to make even risky investments appear healthy.

Experts agree that, used properly, CDS are vital tools for managing market risk. But there are perils. Testifying before the House committee Wednesday, Henry T.C. Hu, a finance expert at the University of Texas School of Law, attributed the downfall of American International Group largely to its estimated $440 billion exposure to CDS. “It’s hard to disentangle [AIG's CDS ventures] from the failure of the entity itself,” Hu said.

The enormous leverage assumed by CDS inspired Warren Buffet, in 2003, to warn, “The range of derivatives contracts is limited only by the imagination of man (or sometimes, so it seems, madmen).”

Complicating the picture, CDS are private over-the-counter deals, not traded openly on any exchange. Not only do Washington regulators not monitor these swaps, they are legally prohibited from doing so.

Testifying before the committee, Erik Sirri, director of the SEC’s trading and markets division, pointed out that his agency, charged with regulating broker dealers, is authorized to intervene in the CDS market only in cases of fraud. In recent years, he said, many firms tended to hold their swaps outside the realm of broker dealers, in unregulated corners of the finance industry.

Sen. Tom Harkin (WDCpix)

Both Lukken and Sirri urged lawmakers to consider a model in which separate, global entities act as competitive clearinghouses. But that idea also raised concerns among some Democrats. Rep. Jim Marshall (D-Ga.) wondered how the competitive clearinghouse model would differ from the competitive swap model that many contend just failed. “It would potentially be another layer of lip-gloss,” Marshall said.

On Tuesday, Sen. Tom Harkin (D-Iowa), chairman of the Senate Agriculture Committee, held a similar hearing on CDS, concluding that legislation will be needed to rein in the industry.

“The credit-default swaps and derivatives have been put together by mathematics and physics geniuses, but carried out without an understanding of human behavior and market behavior,” Harkin said. “We must have regulations that will protect the rest of the economy from the excesses of the financial markets.”

If, indeed, the absence of a regulated derivatives market is partly to blame for the current economic crisis, both parties share the responsibility for bringing that environment about. In late 2000, Congress passed an enormous end-of-the-year spending bill packed to the gills with goodies. One law tucked into that package was the Commodity Futures Modernization Act (CFMA), which explicitly prohibits Washington regulators from overseeing CDS. Congress passed the bill easily, and President Bill Clinton signed the legislation into law later in the month.

A description of the CFMA says it would “promote legal certainty, enhance competition, and reduce systemic risk in markets for futures and over-the-counter derivatives.” Now some lawmakers are looking back on the passage of that bill will rueful eyes.

“Instead of alleviating risk,” Rep. Earl Pomeroy (D-N.D.) said Wednesday, “we compounded it.”

In the face of the scrutiny, voices for the derivatives industry insist that it’s been wrongly blamed. Appearing before the House panel Wednesday, Robert Pickel, CEO of the International Swaps and Derivatives Assn., defended the industry, placing the blame for the mess squarely on “ill-advised mortgage lending.”

“Both the role and effects of CDS in the current market turmoil have been greatly exaggerated,” Pickel said. “To say that CDS were the cause, or even a large contributor, to that turmoil is inaccurate and reflects an understandable confusion of the various financial products that have been developed in recent years.”

Such responses didn’t go over so well with the primarily Democratic House panel. Rep. Tim Walz (D-Minn.) said Pickel’s argument represents a delusional optimism about the industry’s role in the crisis — “like the band playing on the Titanic.”

Peterson also had a terse message for the industry. “Your folks need to get real,” he told Pickel, “if they think they’re not going to get regulated.”