The Wall Street Journal reports that Barack Obama’s favorite capitalist, Warren Buffet, is seeking an exemption from Obama-endorsed derivatives rules for his insurance-and-everything conglomerate, Berkshire Hathaway.
Derivatives are risk-shifting financial contracts that Buffet infamously described as “weapons of financial mass destruction.” After the 2008 financial crisis, Buffet decided to join the nuclear club and Berkshire has amassed a $63 billion derivatives portfolio.
At issue is a proposed new rule in the Senate financial reform legislation requiring everyone who buys, sells, or trades derivatives to post collateral: cash or cash equivalents to protect against losses on the contract. Buffet doesn’t want the new rules to apply retroactively to contracts his company has already written.
Buffet has a fair point on retroactivity: Congress should not rewrite contracts already in force. But the retroactivity argument obscures a larger point: why should anyone be required to post margin on a derivatives trade?
Traditional regulatory principles require financial intermediaries such as banks and brokers to retain capital or post margin to protect against losses and to ensure the institution can meet it obligations. Capital rules are applied to financial intermediaries because their failure would affect other customers and the economy more generally.
Ordinarily, however, government capital rules don’t apply to customers of banks and brokers (there are very limited and specific exceptions). Banks and brokers often impose down payment, margin, collateral, surety or similar requirements on their customers, but that is a judgment for the bank, not for the government. The government looks at a bank’s entire portfolio and sets capital requirements high enough to protect the bank, not to protect every individual loan.
Because the government chose to bail-out insurance giant AIG following losses on derivatives contracts, Congress has decided that customers who buy and sell derivatives, not just the banks that trade them, have to post collateral. But even if there is a case that very big players – such as AIG or Berkshire – represent “systemic risks,” justifying a capital requirement, the Senate bill is a massive over-reaction, requiring every buyer and every seller to post collateral for every trade.
Perversely, the burden of collateral requirements won’t be felt most harshly by the big boys (Berkshire has plenty of cash), but by small users who represent no systemic risk whatsoever. The result will be that derivatives are more expensive, and used less often to mitigate risk.
There are refined tools that Congress and regulators can use to promote stability in derivatives markets. The problem with the Senate derivatives bill is that Congress doesn’t understand markets, so it tries to regulate everything. It is not Warren Buffet who will be hurt most, retroactivity or not, but marginal businesses that will no longer have affordable ways to mitigate financial risks.