A Depressing Look Back

Wapo undresses Rubin, Greenspan, Gramm, Levitt, etc.

The Washington Post has some enlightening historical reporting today on a series of Clinton Administration battles that left the market for derivatives unregulated, contributing mightily to the current crisis.

The story follows a New York Times piece we liked last week on Alan Greenspan’s central role in allowing the financial system to head off the cliff. Brooksley E. Born, Clinton’s head of the Commodity Futures Trading Commission issued stark warnings on the threat of unregulated derivatives and tried to get something done. If she had succeeded it would certainly have moderated this crisis. But Greenspan and then-Treasury Secretary Robert Rubin and Arthur Levitt of the SEC (and the Treasury’s Larry Summers) battled her tooth and nail.

The Post gets inside a critical meeting in 1998 where Greenspan, Rubin, and Levitt shut down Born’s plea for oversight, though she kept fighting an extraordinary intra-government battle with them.

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.”

The story shows that the regulation battle goes deeper than simple partisanship. Rubin Democrats were big deregulators (or non-regulators to be precise), too, though not nearly so much as the current Bush Administration. Rubin himself comes off looking terrible in the story, largely in his own words, which are insider-y and milquetoast:

Rubin, in an interview, said of Born’s effort, “I do think it was a deterrent to moving forward. I thought it was counterproductive. If you want to move forward … you engage with parties in a constructive way. My recollection was, though I truly do not remember the specifics of the meeting, this was done in a more strident way”…

Asked why he didn’t suggest stricter capital requirements as an alternative in 1998, Rubin said, “There was no political reality of getting it done. We were so caught up with other issues that were so pressing… . the Asian financial crisis, the Brazilian financial crisis. We had a lot going on.”

So Rubin says he was too busy and Born was too assertive to get oversight in place even though it was needed? Even after the notorious Long Term Capital Management meltdown threatened the entire system in 1999, he didn’t do anything.

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.

Of course he did.

Former top McCain economic adviser Phil “Nation of Whiners” Gramm had a prominent role in this:

Throughout much of 2000, lobbyists were flying in and out of congressional offices. With Born gone, they saw an opportunity to settle the regulatory issue and perhaps gain even more. They had a sympathetic ear in Texas Sen. Phil Gramm, the influential Republican chairman of the Senate Banking Committee, and a sympathetic bill: the 2000 Commodity Futures Modernization Act.

Gramm opened a June 21 hearing with a call for “regulatory relief”…

Gramm was holding out for stronger language that would bar both the CFTC and the SEC from meddling in the swaps market. Alarmed, SEC lawyers argued that the agency at least needed to retain its authority over fraud and insider trading. What if a trader, armed with inside knowledge, engaged in a swap on a stock? Treasury Undersecretary Gary Gensler brokered a compromise: The SEC would retain its antifraud authority but without any new rulemaking power.

On the night of Dec. 15, with the nation still focused on the Supreme Court decision three days earlier that settled the 2000 presidential election in George W. Bush’s favor, the act passed as a rider to an omnibus spending bill.

Let’s be clear, and as the Post points out, swaps didn’t create this bust—cheap money and bad lending did. But swaps are playing a critical role in turning this mess into an existential crisis for the entire system. By magnifying the bets, they multiplied the losses. And by making investors at the time think they were hedging their risk, they took much more of it. Because these derivatives are unregulated, companies like AIG could “insure” against losses without putting nearly enough capital in reserves.

We know the rest of that story. A credit to the Post for an instructive post-mortem.

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Ryan Chittum is a former Wall Street Journal reporter, and deputy editor of The Audit, CJR's business section. If you see notable business journalism, give him a heads-up at rc2538@columbia.edu. Follow him on Twitter at @ryanchittum.