the economy of the entire planet…

Posted on Monday 29 December 2008

I was reading Part 1 of the Washington Post’s Series on the financial crisis, and ran across this article from October. It’s followed by an 2003 interview with Brooksley Born, the head of the Commodity Futures Trading Commission when these events occurred. It’s a tragic story…
What Went Wrong
By Anthony Faiola, Ellen Nakashima and Jill Drew
Washington Post
October 15, 2008

A decade ago, long before the financial calamity now sweeping the world, the federal government’s economic brain trust heard a clarion warning and declared in unison: You’re wrong.

The meeting of the President’s Working Group on Financial Markets on an April day in 1998 brought together Federal Reserve Chairman Alan Greenspan, Treasury Secretary Robert E. Rubin and Securities and Exchange Commission Chairman Arthur Levitt Jr. — all Wall Street legends, all opponents to varying degrees of tighter regulation of the financial system that had earned them wealth and power.

Brooksey BornTheir adversary, although also a member of the Working Group, did not belong to their club. Brooksley E. Born, the 57-year-old head of the Commodity Futures Trading Commission, had earned a reputation as a steely, formidable litigator at a high-powered Washington law firm. She had grown used to being the only woman in a room full of men. She didn’t like to be pushed around.

Now, in the Treasury Department’s stately, wood-paneled conference room, she was being pushed hard.

Greenspan, Rubin and Levitt had reacted with alarm at Born’s persistent interest in a fast-growing corner of the financial markets known as derivatives, so called because they derive their value from something else, such as bonds or currency rates. Setting the jargon aside, derivatives are both a cushion and a gamble — deals that investment companies and banks arrange to manage the risk of their holdings, while trying to turn a profit at the same time.

Unlike the commodity futures regulated by Born’s agency, many newer derivatives weren’t traded on an exchange, constituting what some traders call the "dark markets." There were now millions of such private contracts, involving many of Wall Street’s top firms. But there was no clearinghouse holding collateral to settle a deal gone bad, no transparent records of who was trading what.

Born wanted to shine a light into the dark. She had offered no specific oversight plan, but after months of making noise about the dangers that this enormous market posed to the financial system, she now wanted to open a formal discussion about whether to regulate them – and if so, how.

Greenspan, Rubin and Levitt were determined to derail her effort. Privately, Rubin had expressed concern about derivatives’ unruly growth. But he agreed with Greenspan and Levitt that these newer contracts, often called "swaps," weren’t exactly futures. Born’s agency did not have legal authority to regulate swaps, the three men believed, and her call for a discussion had real-world consequences: It would cast doubt over the legality of trillions of dollars in existing contracts and create uncertainty over how to operate in the market.

At the April meeting, the trio’s message was clear: Back off, Born…

Then, in September a crisis arose that gave credence to Born’s concerns.

Long Term Capital Management, a huge hedge fund heavily weighted in derivatives, told the Fed that it could not cover $4 billion in losses, threatening the fortunes of everyone from tycoons to pension funds. After Russia, swept up in the Asian economic crisis, had defaulted on its debt, Long Term Capital was besieged with calls to put up more cash as collateral for its investments. Based on the derivative side of its books, Long Term Capital had an astoundingly high debt-to-capital ratio. "The off-balance sheet leverage was 100 to 1 or 200 to 1 — I don’t know how to calculate it," Peter Fisher, a senior Fed official, told Greenspan and other Fed governors at a Sept. 29, 1998, meeting, according to the transcript.

Two days later, Born warned the House Banking committee: "This episode should serve as a wake-up call about the unknown risks that the over-the-counter derivatives market may pose to the U.S. economy and to financial stability around the world." She spoke of an "immediate and pressing need to address whether there are unacceptable regulatory gaps."

The near collapse of Long Term Capital Management didn’t change anything. Although some lawmakers expressed new fervor for addressing the risks of derivatives, Congress went ahead with the law that placed a six-month moratorium on any CFTC action regarding the swaps market.

The battle left Born politically isolated. In April 1999, the President’s Working Group issued a report on the lessons of Long Term Capital’s meltdown, her last as part of the group. The report raised some alarm over excess leverage and the unknown risks of the derivative market, but called for only one legislative change — a recommendation that brokerages’ unregulated affiliates be required to assess and report their financial risk to the government.

Greenspan dissented on that recommendation.

By May, Born had had enough. Although it was customary at the agency for others to organize an outgoing chairman’s going-away bash, she personally sprang for an ice cream cart in the commission’s beige-carpeted auditorium. On a June afternoon, employees listened to subdued, carefully worded farewells while serving themselves sundaes.

In November, Greenspan, Rubin, Levitt and Born’s replacement, William Rainer, submitted a Working Group report on derivatives. They recommended no CFTC regulation, saying that it "would otherwise perpetuate legal uncertainty or impose unnecessary regulatory burdens and constraints upon the development of these markets in the United States"…
A Conversation With Brooksley Born
(Appeared in Washington Lawyer, October 2003)

One major issue was the enormous growth of over-the-counter derivatives. OTC derivatives had been legally permitted for the first time in 1993 by a regulatory exemption that Wendy Gramm had adopted as virtually her last act as CFTC chair. This allowed the growth of a business that is now estimated at over a hundred trillion dollars annually in terms of the notional value of contracts worldwide. Alan Greenspan had said that the growth of this market was the most significant development in the financial markets of the 1990s. The market was virtually unregulated and many, many times as big as the trading on the futures exchanges…

I became enormously concerned about OTC derivatives and thought the market was a nightmare waiting to happen. About three months before we knew about Long-Term Capital Management, the commission came out with a concept release in the Federal Register asking for input from the industry and other interested people concerning the need for more oversight of the over-the-counter derivatives market. I was particularly concerned that there was no transparency. No federal regulator knew what kind of position firms like Long-Term Capital Management and Enron had in the derivatives markets…

How was the concept release received?
There was a firestorm of criticism from the large OTC derivatives dealers, and they were supported by other financial regulators.

What was the ultimate outcome of the regulatory effort?
It wasn’t a regulatory effort. We were just asking questions! The concept release didn’t propose any rules. Alan Greenspan, Arthur Levitt, and Robert Rubin all said that these questions should not be asked and urged Congress to pass a bill that would forbid the commission from taking any regulatory steps on over-the-counter derivatives. There were no hearings on that bill, but during a congressional conference committee meeting on an appropriations bill, an amendment was added preventing the commission from taking any action on over-the-counter derivatives for six months. This occurred within a month after Long-Term Capital Management’s collapse! I thought it was very bad policy, but on the other hand it was Congress’s decision to make, and having made that decision Congress relieved the commission of its responsibility, so that Enron, for example, became the Congress’s responsibility, not the Commission’s…
My apologies for the length of this post. I couldn’t figure out how to shorten it and convey its absurdity. Brooksley Born offered us the opportunity to head off this crisis involving the "Derivatives" Market in 1999, and it wasn’t just that no one listened, she was actively stiffled. In 2000, Senator Phil Gramm [husband of Wendy Gramm who opened the door on Derivative trading in the U.S. in 1993 while at the CFTC and later was on the Board of Enron] passed legislation that was never discussed on the floor of Congress] that banned regulation of Derivative Trading permanently. It’s hard to fathom how much damage this little piece of skullduggery has done to the economy of the entire planet. No matter how hard Born tried to respond to Greenspan’s objections to looking into regulating the Derivatives Markets, he was unmoved. That’s the bottom line. It was more than the ideology of Ayn Rand, more than his "faith in the Free Market economy." Alan Greenspan was working for the Marketeers, not the Markets or "the people"…

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