FT Reports Blanche Lincoln Proposal For CDS Spinoff Set To Pass

In a stunning development, and what may be the biggest loss for the Federal Reserve's lobbying power in history, the FT reports that "Banks are likely to lose a key lobbying battle in the US over whether they will be forced to spin off their lucrative swaps desks, according to people familiar with financial reform negotiations in Congress. Defeat, which would be a further blow to Wall Street, has been made more likely by Paul Volcker, the influential former Federal Reserve chairman, softening his opposition to the provision." If this indeed happens, the fallout for the US financial system will be dramatic, as numerous Wall Street spin offs would have to occur immediately in order to preserve CDS trading, an event that would will also adversely impact valuation multiples. The biggest problem with the Blanche Lincoln proposal, however, is that it still appears nobody really knows just what its full implications are. And adding more fuel to the fire, is the latest whisper from Volcker, whom many thought had relented on toning down his Volcker proposal to prohibit prop trading by banks: "Some senators want to modify the Volcker Rule, which also prevents banks from owning or sponsoring hedge funds in the name of risk reduction, to allow banks to “organise” a hedge fund and make an investment in a small amount of capital alongside a customer. But Mr Volcker thought that would be the thin end of the wedge, adding “from my point of view, I’d like it pure”. Could Wall Street be finally losing its tentacular grip over Washington? We, for one, will not believe it until we see it: after all Chris Dodd and Barney Frank's unfettered access to lifelong indulgences from the Clearing House Association lies in the balance.

More from the FT:

Blanche Lincoln, the Senate agriculture chairman, is the lead proponent of the plan, which would force banks to create a separately capitalised subsidiary to house the derivatives dealing operations – a significant source of profits for big banks, such as JPMorgan Chase.

The expensive restructuring could drive activity out of the largest Wall Street banks and into more lightly regulated rivals and overseas competitors, according to the Federal Reserve and Federal Deposit Insurance Corporation, which oppose the plan.

Mr Volcker – who has become a talisman of the financial reform effort ever since the “Volcker Rule” to force banks to end proprietary trading was embraced by Barack Obama, US president, in January – previously opposed the Lincoln provision.

Although he declined to say whether he now supported it, Mr Volcker told the Financial Times that his earlier criticism was based on the belief that a stricter spin-off was in the works and it was now a “relevant question” whether damage would be done if swaps desks could be kept within a bank holding company.

“I tend to think of the bank holding company as the relevant organisation,” he said.

Mr Volcker added that it would be a mistake to ban banks from using swaps to hedge risk or from facilitating a customer who wants to hedge risk. “There was confusion about that – that’s the kind of thing I certainly would not do,” he said.

There remains disagreement over whether the legislation as currently drafted would prevent a newly capitalised swaps desk from selling a swap to a customer or from using them for its own hedging purposes. Ms Lincoln says it does not; many lawyers say it does.

Negotiations over the text, which is due to go to the White House to be signed into law by the end of next week, are focused on ensuring that those activities are preserved rather than removing the rule entirely, according to people familiar with the talks. However, that does not satisfy the industry or its regulators.

Should CDS trading be forced to move offshore, the question is "where?" -  with Germany, and soon all of Europe, set to forbid unhedged CDS exposure (and if you thought Goldman selling CDO as unhedged pirncipal was tough explaining to the Senate, wait till someone explains that the CDS market will effectively have to collapse by a factor of 10 for its to be feasible) will China be the only place left where CDS traders are allowed to trade unregulated?