New law means taxpayers must back banks' 'incredibly risky' derivatives deals, Rep. Mark Pocan says

Most of us don't deal in investments known as derivatives, but most of us use banks.

That means we should worry about the so-called "cromnibus bill" passed recently by Congress, according to U.S. Rep. Mark Pocan, D-Madison.

"Our taxpayer money will back them up on these incredibly risky ventures for the biggest banks out there that do these," Pocan said Dec. 17, 2014 on a Madison-area liberal talk show.

So, Pocan is claiming that derivatives are "incredibly risky" financial ventures.

And that the new federal law requires taxpayers to back up banks that lose money on them.

"Cromnibus"

As Pocan indicated, Congress approved a major bill that includes a provision affecting derivatives.

The $1.1 trillion measure, signed by President Barack Obama the day before Pocan made his claim, avoided a government shutdown.

In the word "cromnibus,"  the "cr" refers to a Continuing Resolution, or a stop-gap spending bill, to keep the Department of Homeland Security operating into February 2015. And omnibus refers to a catchall bill to fund the rest of the government, through September 2015.

Derivatives

Derivatives, as PolitiFact National has reported, are an unusual kind of an investment whose value depends on an underlying asset.

For example: An airline has to buy jet fuel over the coming year to run its planes. If oil prices skyrocket, the airline loses money. So it enters into an agreement that will pay if oil prices increase, lowering its potential for losses.

So, derivatives aren’t inherently bad or high-risk.

But as the Washington Post’s Wonkblog has observed, before the 2008 financial crisis "Wall Street firms used more complicated derivative formulas to place risky bets on the mortgage market." They were at the center of the financial meltdown.

The risk

The financial crisis led to the 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act. One of its rules requires banks to push some derivatives trading into separate units that do not have access to federal deposit insurance.

In other words, banks could continue to hold derivatives, but in special subsidiaries that didn’t benefit from government backing in the form of FDIC insurance.

Since Dodd-Frank took effect, banks have sought to change that rule so they can once again use their deposits to underwrite some more complex derivative trades. And the cromnibus bill rolls back that Dodd-Frank provision.

The libertarian Reason Foundation worried about the rollback:

"The Dodd-Frank rule prevented traditional banks from betting on financial derivatives with federally insured deposits. The banks could still trade in such exotic securities, but they had to do so with their own capital stock, through non-bank affiliates unsecured by FDIC backing. The idea was to prevent future bailouts like the ones that took place" in 2008.

Two national financial publications, however, saw more of a middle ground.

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Wall Street banks such as Citicorp and J.P. Morgan Chase & Co. were "thrilled" with the change made by the cromnibus. But the measure "doesn’t completely let them off the hook," the Wall Street Journal wrote.

The change would affect requirements under the Dodd-Frank law that banks spin off certain derivatives-trading activities into units that don’t enjoy access to the government safety net.

But the banks would still have to spin off certain riskier derivative transactions "that helped bring American International Group Inc. to the brink of failure in the 2008 financial crisis."

Similarly, the Fiscal Times concluded that the cromnibus provision does not mean "that when banks lose money on swaps and derivatives trades, the Federal Deposit Insurance Corporation will have to make them whole. It also doesn’t suggest that, when a bank fails, the taxpayers have to bail out depositors.

"The money the FDIC holds in the Deposit Insurance Fund, and uses to reimburse depositors in failed banks, doesn’t come from taxpayers. It comes from the banks themselves. Secondly, there is no sense in which the FDIC is on the hook to make banks whole if a swaps deal or derivatives trade goes bad. The FDIC insures deposits – hence the name – not the bank itself."

New York University finance professor Stephen Figlewski, founding editor of the Journal of Derivatives, also staked out more of a middle ground in sizing up Pocan’s claim.

Only a small number of the derivatives deals could be considered "incredibly risky," he told us, noting that because of other Dodd-Frank provisions, derivatives have become considerably less risky.

And while it is true that taxpayers bear some risk, given that the government guarantees banks as a whole, the risk to taxpayers "is much less than (Pocan) wants you to think," Figlewski said.

Louisiana State University finance professor Don Chance, the author of two books on derivatives, also told us Pocan’s claim is partly correct but goes too far.

Our rating

Pocan said that under the federal "cromnibus" law, taxpayers must guarantee "incredibly risky" derivatives deals made by the nation's largest banks.

The federal spending measure does include a provision that makes it easier for banks to use federally insured funds to invest in some investments known as derivatives. But not all derivatives are considered high-risk investments, and there is disagreement over just how much risk the new provision poses for taxpayers.

For a statement that is partially accurate but leaves out important details, our rating is Half True.