A few months back, The Audit’s Elinore Longobardi took a a long look at how the press failed in its coverage of a 1994 report on derivatives regulation from the Government Accountability Office, the nonpartisan investigative arm of Congress.
The study, headed by James L. Bothwell, then director of financial institutions and markets issues at the GAO, came on the heels of a series of disasters, including the bankruptcy of Orange County, California, in the fast-growing derivatives markets. The report flashed red about the need to regulate what was (and would, alas, remain) a veritable Wild West of financial “innovation”:
Much OTC derivatives activity in the United States is concentrated among 15 major U.S. dealers that are extensively linked to one another, end-users, and the exchange-traded markets…
This combination of global involvement, concentration, and linkages means that the sudden failure or abrupt withdrawal from trading of any of these large dealers could cause liquidity problems in the markets and could also pose risks to the others, including federally insured banks and the financial system as a whole.
Although the federal government would not necessarily intervene just to keep a major OTC derivatives dealer from failing, the federal government would be likely to intervene to keep the financial system functioning in cases of severe financial stress. While federal regulators have often been able to keep financial disruptions from becoming crises, in some cases intervention has and could result in industry loans or a financial bailout paid for by taxpayers.
That wasn’t all. Bothwell was back in front of Congress in 1996 reporting that the cosmetic measures the industry had made to preempt regulationwere insufficient.
We thought it would be interesting to see what the author of those reports had to say fifteen years later, in the wake of a disaster that has proved the GAO right—especially since the financial press has done little or no recent reporting on the happenings of 1994 (something that might be illustrative as the financial industry battles to preserve the status quo even now).
I caught up with Bothwell, who now owns Financial Market Strategies LLC, over lunch in Alexandria, Virginia, to talk about his hard-hitting, clear-eyed report, the reaction to it, and the similarities to today’s crisis.
THE AUDIT: I was just reading the new Gillian Tett book about the genesis of credit-default swaps at JP Morgan, and she calls the failure to regulate derivatives in 1994 “one of the most startling triumphs for a Wall Street lobbying campaign in the twentieth century.” What happened?
JAMES L. BOTHWELL: This report created a firestorm of industry and regulatory backlash after it was issued. The industry financed and formed a tremendous backlash to defeat our legislative recommendations. This consumed me for almost twelve to eighteen months, talking about this report and defending its recommendations.
TA: We’re just now coming out of three decades where a zealot like Alan Greenspan was considered mainstream, celebrated as an oracle, the “maestro”—a financial god, essentially. That’s the environment that your report came out into. Did you think you’d face the resistance that you did from people in power, especially from the Clinton administration? They campaigned in ‘92 as sort of anti-Wall Street.
JB: They started lobbying me before the report came out. I knew exactly the extreme resistance we were going to get.
TA: The Clinton administration did? Was that inappropriate for them to lobby you while you were working on it?
JB: Yes, I think so.
As part of the audit process, whenever we have a draft you always let the auditee review the draft and comment on it. This one we knew they (regulators and derivatives dealers) were marshaling their forces already. They knew it was coming. Then we actually had a joint meeting in this big formal briefing room and we called them all in. And we were carefully guarding the draft and gave the industry and all the relevant regulators the draft to review on-site at GAO.
Rather than give us comments the regulators were just taking extensive notes about what it said and what was the logic of the argument—they wanted to inform their counteroffensive.
TA: This was a Democratic administration. That’s pretty remarkable, right? Why was the administration so lined up against regulating derivatives?
JB: Because it was a very profitable business and it was growing dramatically, even back then. The false argument they give you is that if you regulate you’re going to drive the business offshore. They’ve been saying that for decades and we really haven’t seen much evidence of it, but it’s connections to Wall Street. Bob Rubin. The ties are deep.