Publish date:

Derivatives Changes Don't Look So Tough for Banks

The derivatives proposals put forth by Sen. Blanche Lincoln now seem likely to pass but their interpretation may not be as restrictive for banks as originally feared.



) -- It is starting to look like derivatives proposals put forward by Senator Blanche Lincoln (D-Ark.) have a decent shot at passing.

Lincoln's proposals, also known as Section 716 of the Senate's financial reform bill, would seem to require banks to spin off their swaps businesses, which represent the bulk of their derivatives operations.

Swaps dealers would also be prohibited from getting federal support -- whether that means borrowing money at the

Federal Reserve

discount window or having customers' deposits backed by federal deposit insurance.

Don't Miss Which Bank is Least Vulnerable to Reform?

The overall impact of these changes on banks is still somewhat unclear. But as Section 716 gains steam, the likelihood that it will be as bad for giant institutions like

Goldman Sachs

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


JPMorgan Chase

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

TheStreet Recommends



(C) - Get Citigroup Inc. Report


Bank of America

(BAC) - Get Bank of America Corp Report

as many originally imagined appears to be diminishing.

Following her re-election last week, Lincoln received letters of support from both Dallas Fed President Richard Fisher, and his Kansas City counterpart Thomas Hoenig. The Fed presidents' letters are identical in their wording, and they interpret Section 716 to mean banks would be allowed "to hedge their own portfolios with swaps or to offer them to customers in combination with traditional banking products."

Assuming they are correct in their interpretation, it eliminates a fear one savvy banking industry analyst voiced to me that banks would not be allowed to offer mortgages because they would not be able to use hedging to offset the risk of the loan.

The letters also say the swaps activities "should be placed in a separate entity that does not have access to government backstops." That would seem to mean the bank holding companies would be able to house the business. In other words, JPMorgan can still be a swaps dealer, it just can't fund its swaps business out of the bank.

That means the swaps business will be more expensive to operate. Also, because much of it looks likely to be moved to an exchange, it will be even less profitable. But it won't go away entirely.

Still, the Lincoln proposals have a real stigma attached to them. They are seen by many as the nuclear bomb in financial services reform, which is why many analysts have assumed it won't pass.

Now it looks like they may pass, and there's likely some headline risk for the big bank stocks when that happens. But, since the proposals probably aren't as punitive as they have been perceived to be, any resulting pullback in the bank stocks might actually present a good buying opportunity.

--Written by Dan Freed in New York