Untangling Wall Street's tricky bets

WASHINGTON (CNNMoney.com) -- One of the key pieces of the Wall Street reform puzzle in Washington is regulating the complicated financial bets that fueled the mess of the past three years.

They're called derivatives, because their value is derived from other financial products such as jet fuel contracts or mortgages.

The Senate Agriculture Committee passed a bill Wednesday, on a 13-8 vote, to impose new rules on derivatives. One Republican -- Sen. Chuck Grassley, R-Iowa -- joined Democrats in passing the bill, which is expected to be combined into a bigger Wall Street reform bill shepherded by Sen. Christopher Dodd, D-Conn.

Many companies and Wall Street banks use derivatives to cut the risk that they'll lose money on a deal. Derivatives are also used to lock in the price of a commodity, the way farmers do with the corn they hope to sell after the harvest.

The problem in the financial crisis was that bets made on the mortgage market failed, in part because many people assumed housing prices - which surged in the mid-2000s - would rise indefinitely.

Those bets were made in the shadows, with no public exposure. So when the housing market crumbled and financial firms started failing, nobody knew the value of these bets, exacerbating the crisis.

Derivatives are why American taxpayers are on the hook for as much as $139 billion to keep American International Group (AIG, Fortune 500) afloat. They also contributed to the fear that the collapse of Lehman Brothers would take down the entire financial system. And they're at the center of the fraud charges leveled last week against Goldman Sachs (GS, Fortune 500) that have given this issue new impetus.

Right now, trades in derivatives are unregulated, and only market insiders know who got what in a deal. Lawmakers in both parties want to change that, agreeing there should be new laws adding layers of transparency to these trades - so, when a big company fails, there's no domino effect or need for a taxpayer clean-up.

But lawmakers disagree about how far transparency and tougher rules should go to prevent future financial collapses.

Legislation regulating derivatives has now cleared two Senate committees and the House, which passed an overall Wall Street reform bill in December.

The Senate Banking and Agriculture committees both have a say on derivatives. Banking monitors the Securities and Exchange Commission and Agriculture monitors the Commodity Futures Trading Commission, which was created to regulate agricultural financial products.

A Senate aide said the Agriculture bill will get melded with the Banking panel-passed bill, which is an overall Wall Street reform measure. And whatever passes in the full Senate has to be reconciled with the House bill before it can be signed into law by President Obama.

Here are some of the provisions to regulate derivatives:

* Require all dealers in derivatives to register with federal regulators.

* Force many derivatives to pass through a third-party middle man, or "clearinghouse," to stop the domino effect when these things fail.

* Require that regulators set minimum capital and margin standards for those making trades.

* Mandate that many derivatives get traded on exchanges, which work like stock exchanges, where the price buyers and sellers are trading a contract is publicly available.

* Continue to allow some companies and manufacturers to trade derivatives unregulated. One example: Airlines could use this type of deal to lock in lower prices for jet fuel to contain costs, when prices go up.

The Agriculture panel would also force banks such as JPMorgan Chase (JPM, Fortune 500) and Bank of America (BAC, Fortune 500) to spin off and separate their units that trade derivatives if they want to remain eligible for federal assistance, such as emergency loans from the Federal Reserve.

Agriculture Committee lawmakers who voted for the bill say commercial banks that have deposits insured by taxpayers should not be involved in making risky bets.

The banking industry says such a move would push such derivatives dealers to go overseas, and hurt U.S. farmers and airlines that need to minimize risk.

Financial lobbyists, generally, say both Senate bills go too far, but that they are willing to abide by some stronger rules.

"Meaningful regulatory oversight plus regulatory transparency are the two keys to ensuring we don't have another AIG on our hands," said Cory Strupp, a lobbyist for the Securities Industry and Financial Markets Association.

All the derivatives bills make it tougher to dupe investors, which is what the SEC accuses Goldman Sachs of doing in allowing hedge fund manager John Paulson of Paulson & Co. to pick and then bet against such products, said Barbara Roper, Consumer Federation of America director of investor protection.

Regulators would be able to inspect exotic derivatives, and many of them would be forced on to exchanges.

"If you have exchange trading, you have real transparency and it's much easier to see if John Paulson is betting against the derivatives," Roper said.