Thu Oct 16th, 2008 at 07:13:14 AM EST
The Washington Post has a noteworthy piece of history up: an episode in the saga of the Anglo Disease. It's the story of how, during Clinton's second mandate, "Bubbles" Greenspan, aided and abetted by then US Treasury Secretary Robert E. Rubin and Securities and Exchange Commission Chairman Arthur Levitt, stood in the way of a determined effort at regulation of credit-default swaps by the Commodity Futures Trading Commission.
The Fed, (then chaired by Greenspan), Treasury, the SEC, and the CFTC, are the four bodies charged with regulatory functions concerning American financial markets. In this case, one of them stuck out like a sore thumb by actually wanting to regulate. But the three others, especially "Bubbles of the Fed", got on the CFTC's case and resolutely fought off the danger.
Brooksley E. Born, from a Washington legal background, was head of the CFTC, and she had become known for expecting regulation to be applied. The CFTC's brief concerns futures markets, but Born was pressing the case for regulation of certain derivatives other than futures:
What Went Wrong
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 get in Born's way, and of course they succeeded, but not without a pitched battle described in detail in the Wapo article, centring first on a President's Working Group on Financial Markets meeting in April, 1998, then:
Born didn't back off on derivatives, either. On May 7, 1998, two weeks after her April showdown at Treasury, the commission issued a "concept release" soliciting public comment on derivatives and their risk.
The response was swift and blistering. Within hours, Greenspan, Rubin and Levitt cited their "grave concerns" in an unusual joint statement. Deputy Treasury Secretary Lawrence Summers decried it before Congress as "casting a shadow of regulatory uncertainty over an otherwise thriving market."
Wall Street howled. "The government had a legitimate interest in preserving the enforceability of the billions of dollars worth of swap contracts that were threatened by the concept release," said Mark Brickell, a managing director at what was then J.P. Morgan Securities and former chairman of the International Swaps and Derivatives Association.
Of course, this was a blockbuster argument of the "too big to fail" variety: regulation "would cast doubt over the legality of trillions of dollars in existing contracts and create uncertainty over how to operate in the market."
There were other arguments, notably from "Bubbles":
Greenspan also argued a free-market view. Self-regulation, he asserted, would work better than the heavy hand of government: Investors had a natural desire to avoid self-destruction, and that served as the logical and best limit to excessive risk.
They fought so well that they finally obtained from Congress a six-month moratorium on the CFTC's activity regarding derivatives. And, in 1999, Born left the CFTC.
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."
The future that Born envisioned turned out to be even riskier than she imagined. The real estate boom and easy credit of the past decade gave birth to more complex securities and derivatives, this time linked to the inflated value of millions of homes bought by Americans ultimately unable to afford them. That created a new chain of risk, starting with the heavily indebted homebuyers and ending in a vast, unregulated web of contracts worldwide.
By appearing to provide a safety net, derivatives had the unintended effect of encouraging more risk-taking. Investors loaded up on the mortgage-based investments, then bought "credit-default swaps" to protect themselves against losses rather than putting aside large cash reserves. If the mortgages went belly up, the investors had a cushion; the sellers of the swaps, who collected substantial fees for sharing in the investors' risk, were betting that the mortgages would stay healthy.
The global derivatives market topped $530 trillion as of June 30 this year, including $55 trillion in the suddenly popular credit-default swaps; that $530 trillion represents all contracts outstanding. The total dollars at risk is much smaller, but still a hefty $2.7 trillion, according to an estimate by the International Swaps and Derivatives Association.
To make sense of those figures, compare them to the value of the New York Stock Exchange: $30 trillion at the end of 2007, before the recent crash. When the housing bubble burst and mortgages went south, the consequences seeped through the entire web. Some of those holding credit swaps wanted their money; some who owed didn't have enough money in reserve to pay.
Instead of dispersing risk, derivatives had amplified it.
Europe: The article, in pursuing the history of derivatives and especially CDSs, mentions the pressure put on the US by European regulatory authorities alarmed by the size of the market and its opacity. But the US stood firm.
What They Said:
Annette Nazareth, SEC's head of market regulation in 1998-9: "It was an absolute siege on regulation."
Phil Gramm chairing a 2000 Senate Banking Committee hearing, pleading for "regulatory relief": I think we would do well to remember the Lincoln adage that to ask a society to live under old and outmoded laws -- and I think you could say the same about regulation -- is like asking a man to wear the same clothes he wore when he was a boy."
Arthur Levitt, with hindsight: "In fairness, while Summers and Rubin and I certainly gave in to this, we were not in the same camp as the Fed... The Fed was really adamantly opposed to any form of regulation whatsoever."
So it was all really "Bubbles"?
Alan Greenspan: "Regulation of derivatives transactions that are privately negotiated by professionals is unnecessary... Regulation that serves no useful purpose hinders the efficiency of markets to enlarge standards of living."
Go on, read the whole article.