In Financial Reform, Rules Made to Be Broken

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Representative Barney Frank, center, participates in a committee meeting on the Senate and House versions of the financial-reform bill

Clarification Appended: June 28, 2010

During the height of the financial crisis, Boston-based financial firm State Street, once one of the safest banks in America, was viewed by investors as a big risk. Eventually, the government had to hand over $2 billion in bailout funds to the bank, which it eventually paid back. One of the main culprits in State Street's fall from grace: highly leveraged investment vehicles, known as conduits, that were kept off balance sheet and wound up costing State Street more than $3.5 billion. Now Congress, as part of the financial-reform legislation, is working on an exemption that would allow State Street to continue creating and investing in such conduits, though because of a separate accounting rule change they would be on balance sheet.

"If you told me 100% that banks would not use their capital to bail out these [conduit] funds, then I would be fine with the exemption," say Raj Date, a former Wall Streeter who now heads the nonpartisan think tank Cambridge Winter. "But the evidence is just the opposite. And it happened just two years ago, and the very bank that is pushing for the exemption, State Street, is the one that [the proposed restriction] would have protected."

Welcome to the wonderful world of financial reform, where rules are set and then it is quickly determined which firms get to ignore them. In the next few days, Congress is expected to wrap up legislation that would overhaul the rules that govern Wall Street. The House and Senate have each passed their version of reform. Now legislators are in the process of settling the differences between the two bills before voting on a final bill. Lawmakers have already come to a number of agreements. A prepaid fund by the banks to cover the cost of bailouts is out. A rule prohibiting transfer fees on debit-card transactions is in. Auto dealers are likely to be exempt from examination from the to-be-created Consumer Financial Protection Bureau, which will be housed at the Federal Reserve.

One of the key issues yet to be resolved is a rule that would govern how much of a bank's own capital can be risked in trading activities. Just weeks ago it looked likely that the so-called Volcker rule, which would ban all banks from proprietary trading — buying and selling for their own account rather than their customers' — and investing in hedge funds, private equity deals and other structured funds. But in the past few weeks, financial-industry lobbyists have been pushing hard to win an exemption that would allow banks to sponsor hedge funds as long as they put only a small amount of the firms' own money into the funds.

Bank executives argue that clients like to see them put some of their money into an investment as a show of confidence and that hedge funds, after all, didn't cause the financial crisis. Among the firms pushing the hardest for the exemptions are investment managers State Street, BNY Mellon and Fidelity. But all the Wall Street firms, including Goldman Sachs, Morgan Stanley and others, would benefit. Republican Massachusetts Senator Scott Brown, whose state is home to both State Street and Fidelity, has reportedly said he won't vote for the financial legislation unless it includes the exemption.

"Some of these investments were bad, but not all of them," says Lawrence Kaplan, an attorney at Paul Hastings Janofsky & Walker in Washington. Kaplan and others believe that the financial-reform bill will eventually cap this type of investing at, say, 5% of a firm's capital. He says that's appropriate. "There is no empirical evidence that hedge funds caused the financial crisis."

But some policy watchers fear that even small bets in the world of structured finance can lead to big losses for otherwise sound banks. "The justification for all of this is that investors want the banks to have skin in the game," says Heather McGhee, who heads up the Washington office of the liberal-leaning policy group Demos. "My problem with it is that it is really taxpayer skin that is being put at risk."

In the case of State Street, starting in 1992 the bank began forming off–balance sheet conduits that required a small investment of capital from the bank to get started. In fact, because they were off–balance sheet, many of the investments never showed up as a drain on State Street's capital. The vehicles, which would be banned under the Volcker rule, then borrowed money from investors on a short-term basis to fund the purchase of long-term bonds. In the beginning, many of the bonds that State Street and others bought with these conduits, sometimes called structured investment vehicles, were safe investments. But by the mid-2000s, State Street's conduits were big buyers of subprime mortgages and other risky bonds. And when the value of the portfolio of long-term bonds fell, State Street was often on the hook for the entire loss, not just the capital it originally put in. By late 2008, State Street had accumulated $29 billion in investments in its conduits, nearly three times the total capital of the firm.

"Some people are saying, Well, let's limit it to 2% of capital that banks are allowed to put into these investments," says Date, who has studied the problems at State Street. "My perspective is, How does zero percent sound?"

The original version of this story failed to make a clear distinction between State Street's off-balance sheet conduit investments and its quest for permission to continue to create leveraged investment vehicles that under FASB rules would be on balance sheet. The current draft of financial reform allows State Street and other banks to own and invest a limited portion of their capital in such funds. Also, the bank was described in the article as becoming one of the "biggest risks" to the financial system during the worst parts of the financial crisis, a description reflecting its size and importance in the US banking system; the fact that its stock price was cut in half; and that it was among the banks receiving money from the TARP program. It should also be noted that months after the worst of the crisis, when big banks were subjected to a financial stress test, State Street ranked among the strongest of the 19 banks tested.