“Words That Work”
“Frankly, the single best way to kill any legislation is to link it to the Big Bank Bailout.”

Republican Pollster Frank Luntz
—January 2010

Frank Luntz is a political consultant who made his bones on the Contract With America, by which Newt Gingrich’s resurgent Republicans wrested control of the House from the Democrats in 1994.

Recently, Luntz has turned his attention to financial reform. His arguments are compelling. As compelling (and potentially as effective) as the arguments he spelled out in his “Language of Health Care” memo, which shaped the Republicans’ response to health care reform.

Seventeen months after the Bush administration’s Treasury Secretary, Henry Paulson, warned House and Senate leadership that the nation’s financial system would collapse without a $700 billion bailout, Luntz has identified the parties responsible for the crisis: “individuals who ran up their credit cards and took out mortgages they couldn’t afford.”

Luntz’s work is formulaic. He uses polling to measure public opinion. Then he identifies inflammatory language that can turn public anger into a campaign. Luntz also found deep wells of public discontent with the Congress regarding the economic collapse and the bailout. The campaign he proposes directs public anger at the “architects of failure” who are now “designing the rescue.”

“The same members of Congress responsible for the legislation that helped create the housing bubble and the Wall Street financial crisis,” Luntz writes, “are now attempting to create another new government agency with an unlimited budget and almost unlimited regulatory powers.”

It is bold of Luntz to go at the “architects of failure.” Most economists agree that the current crisis would not have occurred but for the 1999 Gramm-Leach-Bliley Act. At a breakfast I attended at the 2000 Republican national convention in Philadelphia, Luntz was the guest speaker. He recognized Texas Senator Phil Gramm, describing him as “the perfect Republican senator”—except for his conventional banker’s suit.

Gramm was once a Luntz client. His banking deregulation bill, signed into law by Bill Clinton, eliminated the structural restraints that had prohibited commercial banks from the speculation that last year brought the country perilously close to a major depression.

Gramm was also a cosponsor of the Commodity Futures Modernization Act of 2000, which exempted over–the-counter derivatives from regulation. The unregulated trading of derivatives—in particular credit default swaps—directly resulted in the $181 billion bailout of insurance giant AIG and the collapse of investment bank Lehman Brothers.

That’s two innovations for which Gramm gets credit.

There is a third. Gramm was the author of the so-called “Enron Loophole” in the futures deregulation bill, which exempted the trading of energy, metals, and electricity from federal regulation and resulted in the collapse of Enron (and rolling blackouts in California in 2001.)

If there were a Pritzker Prize for the architecture of financial failure, Gramm’s only competition would be former Treasury Secretary Robert Rubin.

Gramm left the Senate in 2003 to accept a position at Swiss investment bank UBS. His legislative legacy isn’t so easy to get rid of. As chairman of the Senate Banking Committee, he was the architect and agent of deregulation, dismantling the restrictions imposed on banks by the Glass-Steagall Act of 1933.

Here’s the thing. After a global economic disaster that began because banks had been freed from regulation, Republicans in Congress have resolved to block banking regulation. And Frank Luntz has written their playbook. Watch for House and Senate Republicans on TV news programs, their riffs on financial reform built around Luntz’s “words that work”: lobbyist loopholes, bureaucrats, bloated bureaucracy, fine print, another Washington agency, hard-working taxpayers, accountability, wasteful Washington spending, special interests, unlimited regulatory powers, another government bailout. And look for them to get away with blocking reform—with some help from the Democratic majority.

REPUBLICAN TRIFECTA—With cap-and-trade climate legislation dead and health care reform moribund, financial regulation is all that remains of President Obama’s big legislative agenda. Killing financial reform would provide the Republicans a trifecta going into the 2010 elections.

The killing has been underway for a while. A modest financial reform bill passed the House on December 11 by 223-202, without a single Republican vote. The week before the bill passed, the Republican leadership reached out to 100 banking lobbyists. They couldn’t kill the bill. They did, however, find enough conservative Democrats to weaken it.

A few examples.

Illinois Democrat Melissa Bean managed to undermine consumer protection by ensuring that no state can pass stronger consumer safeguards than those defined in the bill. Not only bad policy, but bad politics that turned progressive attorneys general against consumer protection measures in the House bill. (The financial services sector provided 59.6 percent of the $792,301 in campaign contributions that Bean collected in 2009.)

New York Democrat Scott Murphy carried an amendment for the National Association of Manufacturers, eroding provisions that would regulate derivative trading—even after the administration’s moderate provision on derivatives had been watered down by Financial Services chair Barney Frank. Murphy’s derivative amendment was adopted 304-124. (If you’re doing the math, there aren’t 304 Democrats in the House; 131 Democrats joined 173 Republicans.)

Idaho Democrat Walter Minnick came close to replacing an independent Consumer Financial Protection Agency (CFPA) with a powerless Consumer Financial Protection Council. Minnick persuaded 175 Republicans to join 33 Democrats, proving (as Scott Murphy had) that bipartisanship is possible if the policy is bad enough. The amendment failed 208-223.

SENATORIAL COURTESY—Heather Booth directs Americans for Financial Reform, a coalition of more than 200 consumer, labor, and investor groups. In an interview, Booth listed consumer protection (including an independent agency) and the regulation of derivatives as the first two issues on AFR’s legislative agenda.

Booth said that AFR supports “an independent agency with rule-making authority that applies to banks and non-banks and is not subject to veto by any … regulator or any other person or board.” The agency should have an independent budget based on assessment, executives appointed by the president for specific terms, and freedom from supervision by other regulators or boards.

Harvard Law School professor Elizabeth Warren—appointed by Obama to direct the Congressional panel overseeing the bank bailout money—proposed the consumer protection agency. Had Walter Minnick swung nine more votes in the House, it would have died there. Getting the Senate to accept it is going to be a heavy lift.

Luntz singles out the CFPA in his memo: “Ordinarily, calling for a new government program to protect consumers would be extraordinarily popular. But these are not ordinary times. [The American People] are saying ‘hell no‘ to more government agencies.” Luntz’s trope on the CFPA? “Congress is poised to add another Washington agency with more Washington bureaucrats on top of existing laws and regulations.”

In a speech on the Senate floor in November of last year, Richard Shelby, the ranking Republican on the Senate Banking Committee, singled out the CFPA: “An agency that requires financial firms to provide products to consumers repeats the same dangerous practices that led to unqualified consumers receiving mortgages they couldn’t afford.”

That is a peculiar (one might say dishonest) criticism of an agency that would require lenders to verify that borrowers understand risks and have the means to make payments before approving high-risk loans. The CFPA would also have the authority to eliminate fine-print contractual clauses that lock borrowers into arbitration so they cannot take lenders to court. And the agency would create uniform, easily understandable truth-in-lending disclosure forms to be used in all home mortgage transactions.

Luntz’s “word doctor” precept helps explain why Shelby’s criticism doesn’t square with what he’s criticizing: “It’s not what you say, it’s what people hear.”

Equally helpful. Shelby has taken in $5 million in contributions from the finance, insurance, and real estate sectors since he was elected to the Senate in 1986. In a February 8 New York Times story that tracked the movement of Wall Street money away from Obama (who helped Democrats raise an unprecedented $89 million on Wall Street in the last election cycle), David D. Kirkpatrick reported that Shelby was one of five opponents of the president’s regulatory proposals who recently received $10,000 checks from UBS’s political action committee.

SWAPPING DERIVATIVES IN DUBAI—A swap, Eric Dinallo says, is a hedge. “[L]et’s say you own Ford bonds, and you want to hedge your risk that Ford is going to default on those bonds. So you go to a third party and ask them essentially to insure you against that default. That’s the swap … you’re swapping the risk of default with a third party.”

Dinallo was superintendent of the New York State Insurance Department when he made the Congressional committee-hearing circuit in October 2008. On two occasions when I caught up with him, he was focused on credit default swaps, which resulted in the government takeover of AIG.

Dinallo was particularly concerned with naked default swaps, in which neither party in the deal has an interest in the equity that’s insured. “Neither of you own any exposure to Ford,” Dinallo said. “You’re just making a bet. You’re taking a gamble on whether Ford is going to default or enter into bankruptcy or not.”

Then came the scary stuff.

“Estimates of the market were as high as $62 trillion [in credit default swaps],” Dinallo said. “By comparison, as of the second half of 2008, there was only $6 trillion in corporate debt outstanding, $7.5 trillion in mortgage-backed debt, and $2.5 million in asset backed debt …. That’s a total of about $16 trillion in private-sector debt. So it appears that swaps on that debt could total at least three times as much as actual debt outstanding.”

The gross domestic product of the United States that year was $14.25 trillion. Default swaps also totaled at least three times the country’s 2008 GDP. Many of those swaps were side bets on tranches of subprime mortgages and other dicey financial packages. No one could gauge the dollar amount of defaults that would occur if asset values fell below a certain level, because no one knew what was out there. The trading of credit default swaps and other derivatives is unregulated. They trade over the counter in private contracts.

The fix, or at least the general contours of it, seems simple: force derivative traders into regulated clearinghouses or exchanges. Robert Johnson, who had worked as a managing director at Soros Funds and as chief economist for the Senate Banking Committee, made that argument in written testimony submitted to the House Financial Services Committee in October of last year: “Exchange-traded derivative instruments have real prices based on actual transactions, and the exchange imposes real margin (capital set aside) upon participants to insure their ability to honor their contract obligations.” In other words, make traders play in the open and make them pay to play.

Johnson’s testimony (he represented Americans for Financial Reform) also illustrates that what is evident isn’t easy. He warned that Citigroup, JPMorgan Chase, Bank of America, Morgan Stanley and Goldman Sachs hold more than 95 percent of derivatives exposure among the nation’s top 25 bank holding companies.

In the first half of 2009, the big banks earned more than $15 billion by trading derivatives. With that much money in play, it is risible that House Republicans had to recruit bank lobbyists to work on the House financial reform bill.

Where do we stand now? The derivatives-reform language the Obama Treasury Department sent to Congress was weakened by House Financial Services Chair Barney Frank, then amended into what one lobbyist describes as “swiss cheese.” The House’s “derivative reform” leaves as much as 60 percent of trades outside of any exchange or clearinghouse and allows traders to take their business offshore.

“If the American public knew a bill were designed that would allow traders to take their business to Dubai, they wouldn’t be happy,” said AFR’s Heather Booth.

What the American public hears is problematic. Already, a group that calls itself the Committee for Truth in Politics is running ads in six states, using Frank Luntz’s language: falsely claiming that the financial reform bill includes “a new $4 billion bailout for banks.”

WHAT WILL DODD DO?—Financial reform has moved on to the Senate. “We think the derivatives proposals in Senator Dodd’s bill are strong and move things in the right direction,” Booth said.

So all eyes are on Connecticut Senator Chris Dodd. The Senate Banking Committee chairman had cultivated a reputation of fastidiousness about ethical issues, perhaps in response to the Senate censure of his father, Senator Thomas Dodd, in 1967, for misappropriating $100,000 in campaign funds. So it was a surprise when the story broke in 2008 that Chris Dodd got special “VIP” mortgage rates from a subprime lender.

Dodd is retiring next year. If he is auditioning for a banking job, as Phil Gramm did as he left the Senate, look for Dodd to gut the derivative trading provisions in the financial reform bill he drafted. If he’s retiring with his integrity intact, look for him to stand firm on derivative reform.

So far the signs don’t look good. In early February, Dodd started walking away from the Consumer Financial Protection Agency, to accommodate Richard Shelby and report out a bipartisan bill. In a larger sense, the consumer protection agency is a smaller issue. It’s an important piece of the bill, but banks screw consumers on a routine basis without putting the global economy at risk. If Congress gets derivatives wrong, the economy could end up where it was in September 2009.

Yet financial regulation faces steep odds. “As long as Republicans think that just saying “no” is a winning strategy while some Democrats vote like Republicans on regulatory issues, it is very difficult to see where you get 60 votes in the Senate,” said Barbara Roper of the Consumer Federation of America.

The numbers alone are terrifying. In 2008, for example, Bear Stearns had written derivatives contracts backing credit valued at $10.2 trillion, a figure three quarters the size of the U.S. economy. When institutions with balance sheets like that go south, the entire economy goes south with them.

“The regulation of derivatives is arguably the most important thing in there and the most important thing to get right,” said Roper. “It’s also the one thing they are most likely not to get right.”