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Derivatives: Who Has Congress' Ear?

While the populist viewpoint appears to have won today's battle on derivatives reform, the financial and corporate lobby is a lot louder and better capitalized than Main Street's.



) -- Whether or not the

derivatives reform agenda coming out of Washington makes any sense, one thing is clear: The defense is larger, louder and much better capitalized than the offense.

Consumer-advocacy group Public Citizen -- which is distinctly on the offensive line -- says the antireform lobby has "overwhelmingly" usurped the debate.

According to

a study by the group, nearly 1,000 lobbyists have worked to sway legislators since the start of 2009. Those who argue for a laissez-faire approach to derivatives have outweighed the pro-reform set by a ratio of 11 to 1.

"We're completely outnumbered," says Craig Holman, the nonprofit group's sole legislative lobbyist.

For comparison's sake,

Goldman Sachs

(GS) - Get Goldman Sachs Group, Inc. (GS) Report

alone has 21.

Public Citizen analyzed lobbying data for the nine key bills brought before Congress to create a framework for monitoring the derivatives market, which is still largely unregulated. Of the 982 lobbyists scrambling to catch a lawmaker's ear, 903 of them represented the

financial sector or

large corporations that are also against reform.

Among those lobbying hardest against reform provisions have been the American Bankers Association, the Securities Industry And Financial Markets Association, the Managed Funds Association, the American Council of Life Insurers, Goldman Sachs,

CME Group

(CME) - Get CME Group Inc. Class A Report


Prudential Financial

(PRU) - Get Prudential Financial, Inc. Report

on the financial side, as well as the U.S. Chamber of Commerce and National Association of Manufacturers on the corporate side. The Air Transport Association of America was the only group within the top 10 that supported reform.

Banks that would be most affected by legislative reform -- Goldman,

JPMorgan Chase

(JPM) - Get JPMorgan Chase & Co. (JPM) Report


Bank of America

(BAC) - Get Bank of America Corp Report



(C) - Get Citigroup Inc. Report


Morgan Stanley

(MS) - Get Morgan Stanley (MS) Report

-- control 97% of the market and belong to the financial trade groups. It's also worth noting that the financial sector is by far the

top contributor to political campaigns, particularly to politicians leading financial committees in the House and Senate.

Taylor Lincoln, who led the research effort for Public Citizen, adds that the study's distorted lobbying ratio doesn't reflect widespread opposition to the bill. Rather, he says, it reflects the way Washington and corporate America coincide.

"It is not a populist sentiment rising," says Lincoln. "They have a lot of money and a lot of lobbyists."

On Wednesday, Congress' long-running debate on derivatives regulation

took its latest turn when Sen. Chris Dodd (D., Conn.) backed away from a proposal to water down an amendment by Sen. Blanche Lincoln (D., Ark.). Lincoln sponsored an amendment that would force banks to spin off their derivatives businesses entirely. Banks vehemently opposed the idea, and Dodd had suggested giving firms a two-year window to do so.

But after regulators, banks and lawmakers from both sides of the aisle slammed his proposal for days on end, Dodd dropped the idea and went back to the previous amendment-laden draft, hoping to get a resolution by the end of the day.

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The hasty political shift -- which happened over the course of a few hours -- showed how much of a wild card the financial-regulatory reform proposal has become. In this case, it seems, the pro-reform lobbyists won, though that hasn't been the case across the board.

Another amendment from Sen. Ben Nelson (D., Neb.) is less geared toward populist sentiment, but equally poised for passage. Nelson has made the derivatives reform bill only pertain to future contracts -- not the hundreds of trillions of dollars' worth of notional exposure that banks already have on their books. Nelson represents the home state of

Warren Buffett, whose

Berkshire Hathaway


conglomerate has a large derivatives book. Unsurprisingly, Buffett voiced support for the idea of exempting legacy contracts right around the time that Nelson proposed the amendment.

In any case, the fight isn't nearly over. The proposal must still go into conference to be melded with a House measure that passed last year. Public Citizen and its cohorts are concerned that money and power, rather than public interest, will have an undue influence over the way legislation is shaped. Their counterparts worry that populist rhetoric will overrun the debate, and result in measures that are arbitrary, costly and hurtful to their lines of business.

"There's not a large reserve of money to do bidding for the general public," says Lincoln, the Public Citizen researcher. "And so, for all of these issues, going back across the decades, this is how it works. Health care, energy, financial reform, whatever. Whatever the issue of the day is."

Counters Luke Zubrod, a consultant at Chatham Financial, who works with roughly 1,000 derivative end users. The end users he works with run "across the spectrum: Anyone from pro-football teams and trade associations that represent the elderly to REITs -- real estate investment trusts -- to large and small corporations and financial services clients. The vast majority thinks this is bad for banks, bad for end users, and bad for America. But for fear of being caught in the toxic current of politics, none

of the lawmakers want to say so."

So what's the takeaway for Main Street in all this?

First, it would help to understand that derivatives aren't all evil and to understand why banks and certain corporations are fighting reform - whether right or wrong in that effort.

At the moment, derivative contracts are traded "over the counter" -- in other words, backroom deals that are not priced on a public exchange, not cleared through a centralized clearinghouse and not directly regulated. The Dodd proposal would force plain-vanilla contracts onto such exchanges and put margin and capital requirements place. It would allow OTC transactions to take place, although they would require higher margins and capital than exchange-traded products.

Banks don't like the proposals because they say costs of compliance will rise. End-users don't like the proposal because they fear those costs will be passed down the line. For instance, the Lincoln amendment also would force banks to make a choice: Get rid of your derivatives business, or cough up the capital needed to spin it off into a stand-alone entity. Ultimately, the decision would come down to whether or not end-users would be willing to finance such a move.

It's also probably true that neither side likes it because they each believe they're smarter than everyone else: Banks would rather set their own prices than face competition on an exchange, while end-users believe their prices are better than everyone else's and they'll be forced to pay more on an open exchange.

" Basically, the banks and bank lobbyists are trying to protect the bottom line," says Holman.

Furthermore, shedding light on an industry that has operated behind closed doors doesn't make any of the affected parties all that comfortable. As an extreme example, take the high-profile

Goldman Sachs

(GS) - Get Goldman Sachs Group, Inc. (GS) Report

derivatives transaction in 2007, nicknamed "Abacus."

The counterparties that were long subprime housing look moronic, even if they garner sympathy for having lost $1 billion on the deal. Paulson & Co., the hedge fund that shorted the deal, looks like a villain that bet against the American dream, albeit a savvy one.

For its part, Goldman looks like a weasel that offered clients a deal that it believed would go sour and ultimately bet against them. The colorful -- and at times profane --

email exchanges that have been unveiled as part of regulatory and congressional investigations haven't helped.

"Goldman was the gold standard of the investment banking, finance community," says Ron Geffner, a lawyer who represents financial firms. "And now it's hard to not have doubts about their business and their operations -- whether you were a believer in them or not."

But while some derivatives can be incredibly dangerous, as in the case of

American International Group

(AIG) - Get American International Group, Inc. Report

and its taxpayer-financed bailout -- they're not all created alike. There are other, more practical uses for derivatives as well, which serve as a safety net for an array of industries.

Retailers, like

Coca Cola

(KO) - Get Coca-Cola Company Report

, that buy and sell products across international markets, use derivatives to offset currency swings. Airlines, like


(DAL) - Get Delta Air Lines, Inc. Report

, use fuel hedges to protect against wild fluctuations in oil prices. Companies with riskier balance sheets, or sectors that aren't performing very well, implicitly rely on bond insurance products called credit-default swaps to access financing in the debt markets. Banks use derivatives to offset big interest rate changes, as do just about any other companies with a reasonable amount of debt.

Ultimately, the argument goes, derivatives make the cost of consumer products cheaper, because they remove risk from the production line.

For example, Rochdale Securities analyst Richard Bove outlined several points that Goldman Sachs could have used to explain to the average citizen why its role in the financial markets is critical, if misunderstood: "By raising money to help fund the national deficit, the company helps keep taxes down. By creating liquidity in the derivatives markets, it keeps interest rates down. By providing liquidity in the commodity markets, it blunts the increase in inflation. By raising funds for start-up technology ventures, it improves any number of parts of the economy. By doing all of the above, it creates jobs."

Still, the hue and cry over derivatives reform may be exaggerated, as it pertains to any negative impact on Main Street.

"What regulation and laws often do is impose rules of fair play to impose upon everybody," says Lincoln. "Every time there's talk of regulation -- going back to seatbelts -- the industry always says the sky is going to fall. My sense is, it's probably the same case here."

-- Written by Lauren Tara LaCapra in New York