May 5, 2010
As the Senate negotiates sweeping changes to financial regulations, some policy experts are flashing back to the late 1990s, when a Clinton administration appointee named Brooksley Born explored oversight of complex financial contracts known as over-the-counter derivatives.
Born, an attorney, chaired the Commodity Futures Trading Commission. Her efforts to shed light on and regulate the opaque world of derivatives quickly died in the face of vehement opposition from then-Federal Reserve Board chairman Alan Greenspan, Treasury secretary Robert Rubin, powerful members of Congress, and Wall Street executives who opposed increased market regulation.
Now that credit default swaps and mortgage-based derivatives have been implicated in the near collapse of the international financial markets, it's only natural to wonder what the world would have looked like if Born and the CFTC had succeeded in bringing transparency to the $600 trillion derivatives market — or even imposing capital and margin requirements.
"It would've prevented the meltdown because there would've been too much information that would have countered the theory that housing prices would always go up," said Michael Greenberger, who was director of the division of trading and markets at Born's CFTC. "If regulators had seen the gambling, they would've seen that the risk was being repeated by multiple institutions."
A Different Kind of Casino
Derivatives are financial contracts that pay off based on the underlying value of a stock, bond, commodity or other asset. In short — it’s a paper bet that the value of that asset will go up or down in the future. Let’s say the asset is oil. You bet that oil prices will go up because of the BP oil spill and the about face on offshore drilling. So you enter into an oil swap that will pay off if the price goes to $100 a barrel. If you bet well, you made a lot of money on the million barrels of oil in your contract. Historically, derivatives have been unregulated because they have been used by corporations, institutional investors and banks deemed to be sophisticated enough to understand the substantial risks.
While their appropriate use can protect companies from an unforeseen drop or rise in a given asset price, their misuse and dramatic growth in the market has led to crises such as the near collapse of Long-Term Capital Management and the recent disasters at Lehman Brothers, American International Group and markets around the world. The widespread use of derivatives to leverage the possible return on firms' trading positions magnified the effect when those positions started to lose their value, leading to a domino effect and market panic.
The CFTC is an independent agency created by Congress with the mandate to regulate commodity futures and option markets in the United States. In 1998, the CFTC stirred up a hornet's nest in the financial policy world by issuing a "concept release," the first step toward possible regulation, which asked for comments on whether the agency should require derivatives dealers to register themselves, report transactions, put up margin, meet capital standards, be subject to anti-fraud requirements or other oversight. After heated debate, Congress passed legislation banning the agency from regulating derivatives -- and then went even further, by completely deregulating the swaps market through the Commodity Futures Modernization Act in 2000.
Born had nothing to say publicly about the unfolding international financial crisis until March 2009, when she said: “The market grew so enormously, with so little oversight and regulation, that it made the financial crisis much deeper and more pervasive than it otherwise would have been.” She declined to comment for this article.
Clinton Passed, but Obama Wants Regulation
Former President Bill Clinton recently acknowledged he was wrong to have taken the advice of Rubin and other top aides when he was president and to have left derivatives unregulated. However, he said he doubted that Congress, which was controlled by the Republicans at the time, would have approved such a regulatory measure.
The derivatives portion of financial regulatory reform, passed by the Senate Agriculture Committee last month and set for a floor vote next week, seeks to ban big Wall Street banks from trading in derivatives. It also would require registration, reporting, margin, capital adequacy, exchange trading and clearing of derivatives. Regulators could take action against derivatives dealers for fraud, manipulation, excessive speculation or for failing in their fiduciary duty to protect municipalities and pension funds that enter into swaps. "We proposed a Chinese menu of options in 1998," said Greenberger, now a law professor at the University of Maryland. "That bill orders everything off the menu and more.” Senate Agriculture Committee Chairman Blanche Lincoln, D-Ark., said on the floor Wednesday that “the operation of risky swaps was really the spark that lit the flame that very nearly destroyed our economy … Wall Street lobbyists are doing everything they can to distort this provision, spreading misinformation and untruths.”
The financial industry is frantically lobbying to defeat the most onerous provisions of the legislation, notably the requirements that the major U.S. banks that do most of the derivatives dealing spin off their swaps divisions. Even financier Warren Buffet has lobbied against a measure requiring firms to post collateral on existing swaps transactions, which reportedly would cost Berkshire Hathaway up to $8 billion.
While it's clear now that Congress shouldn't have exempted swaps from oversight in 2000, the pending legislation is an overreaction bound to cause its own problems and cost the financial sector billions, according to Dan Crowley, a partner and head of the capital markets reform group at K&L Gates.
"The pendulum seems to have swung from one extreme to another, which is to capture and standardize the trading of everything," Crowley said. "I don't think anything in here will allow the regulators to get ahead of the next credit default swap product ... You're going to be stifling growth, imposing new costs and failing to solve the fundamental problem."
But even industry lobbyists acknowledge that if the CFTC had succeeded in bringing transparency to the OTC derivatives market, the global financial crisis might have been averted. If every firm entering into a derivatives deal had to put up margin and possess adequate capital to cover the trade, institutions such as American International Group wouldn't have been able to build up their exposure to many multiples of their net worth.
"The margin and capital requirements contemplated in the current bill would've helped mitigate the risk of AIG's positions in the mortgage markets," said Scott Talbott, senior vice president of the Financial Services Roundtable.
Looking back, it's hard to imagine how the CFTC could have imposed new requirements on derivatives — even simple reporting and registration rules — in a political environment that was so philosophically committed to deregulation, said Dan Waldman, a partner and head of the derivatives practice group at Arnold & Porter, who was CFTC general counsel in the late '90s.
"We lived through a time where regulation was suspect, markets were king, everybody thought these people were so bloody smart," Waldman said. "For those of us who were a little skeptical at the time, you couldn't even whisper that because it was viewed as such heresy. In that environment you wonder, would regulators really have had the ability to rein things in?"