WASHINGTON — Consumer groups on Tuesday accused dealer and derivatives groups of trying to drastically weaken proposed federal rules designed to protect unsophisticated state and local governments in interest rate swaps and other muni-related derivatives transactions.
“Wall Street is doing its best to see that the rules are as weak as possible,” Barbara Roper, director of investor protection for the Consumer Federation of America, told reporters during a teleconference call.
The rules, which were mandated by the Dodd-Frank Act, have been proposed by the Commodity Futures Trading Commission and the Securities and Exchange Commission, which share jurisdiction over interest rate swaps.
“Unfortunately, these new Dodd-Frank [proposed rules] are under attack … through a major lobbying effort by big banks,” said Marcus Stanley, policy director at Americans for Financial Reform, a coalition of more than 250 national, state, and local consumer, labor, investor, civil rights, community, small business, and senior citizen organizations seeking financial reforms.
Without these rules, Roper and Stanley told reporters, there will be more cases like Jefferson County, Ala., which they cited as the “poster” child for questionable derivatives deals.
At one point, the county had more than $3 billion of interest rate swaps that eventually had to be terminated, with firms saying the county owed more than $765 million in termination costs and related expenses. Most of these fees were forgiven as part of the settlement of a federal probe that revealed corruption and conflicts associated with the swaps. The county recently became the largest local government in the nation to file for bankruptcy.
Pennsylvania state auditor Jack Wagner, who also spoke to reporters, said the rules are desperately needed to prevent unsophisticated school districts and local governments from blindly entering into such deals.
In a probe and 2009 report, the state found dozens of school districts, lured by huge up-front payments of cash, had entered into derivatives transactions and were completely unaware of the risks these deals posed or the losses that they could face.
There was no transparency in the deals and many were rife with conflicts of interest, with the advisors to the school districts pushing them to do the derivatives deals from which the advisors would financially benefit, Wagner charged.
“It’s impossible to measure the risks from [these deals],” said Wagner, who has unsuccessfully urged the state’s General Assembly to prohibit school districts and local governments from entering into swaps transactions and derivatives deals.
“When taxpayer money is at stake, [swaps] are not an appropriate vehicle,” another Pennsylvania official said.
Roper said the CFTC first proposed reasonably good business conduct standards for swap dealers last December.
But dealers and derivatives firms opposed many of the provisions and lobbied for changes, she said.
The SEC, which has been working with the CFTC on these rules, proposed its business conduct standards during the summer and significantly weakened many of the provisions that were in the CFTC rules, Roper said.
Now the CFTC is expected to soon reissue proposed rules and they are likely to look more like the SEC’s rules, she said.
The CFTC and SEC proposed business conduct standards containing heightened obligations for swap dealers that provide advice to “special entities” such as state and local governments or pension funds, which must have independent advisors for derivatives transactions.
Under the CFTC rules, when a swap dealer acts as an adviser to a state or local government or pension fund, the dealer must have a reasonable basis for believing that what it is recommending is in the best interest of the special entity.
Swap market participants complained they needed clarification about when a dealer is acting as an advisor.
As a result, the SEC rules allow a swap dealer and a state or local government with an independent advisor to sign a waiver that says the swap dealer is acting as a counterparty in an arm’s-length transaction and that the “best interest” standard does not apply because the government has an independent advisor.
However, under the SEC’s proposed definition, an independent advisor could be someone who was an employee of the swap dealer more than a year ago; has an ongoing business relationship with the swap dealer; or obtains up to 10% of its gross revenues from the swap dealer.
Roper and Marcus contend that under that definition, the advisor would not be independent from the swap dealer.
The CFTC’s proposed rules would require swap dealers to disclose to state and local governments any conflicts of interest and the risks and key characteristics of a swap transaction.
But SEC’s proposed rules would allow the swap dealer to provide those disclosures orally to the government before the transaction occurs.
Roper said she is sympathetic to the industry’s need for clarification and to the regulators’ desire to get the rules right. But she contends that the SEC rules and the expected changes to the CFTC rules will water down the protections so much that they become meaningless.
Stanley said the SEC’s proposed rules contain many “escape hatches” and allow swap dealers to “stipulate away all of the protections” for state and local governments and pension funds.
He accused industry officials of strong-arming their clients to lobby on their behalf after telling them that if these rules go through, they will never be able to do transactions with the clients.
“Let’s put some reasonable protections in place that constrain the ability of swap dealers from engaging in predatory practices and provide additional safeguards for the most vulnerable participants in this market,” Roper said.
