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.

TA: It’s remarkable to look back in this context and see a Democratic administration just shoot down and marshal all its forces against you. I mean, you guys weren’t saying “eliminate derivatives.” You were saying put them on exchanges and have disclosure, things like that.

JB: Yes. If you read our report, it was very well balanced. We talk about the benefits of derivatives for risk-sharing and risk-spreading.

TA: Do you still think—in light of recent events—that they still have a place?

JB: Absolutely, but you need regulatory oversight. You need controls over undue concentrations of market risk, credit risk. Make sure there’s adequate capital.

TA: In that report you were talking about how you thought that derivatives could increase risk while everyone was talking that derivatives would disperse risk throughout the system. You said “maybe not”, especially if you have these guys that are so big that one of them fails and causes a chain reaction. Why were you the only one saying that?

JB: I’d attribute it to my good education—UC Berkeley (laughs), and my intuition, and the analysis of the marketplace.

You saw a marketplace there that was highly concentrated in six major dealers. You saw a marketplace where there was no transparency. Those dealers knew who their counterparties were, but did not know who their counterparties’ counterparties were. There was nobody with the overall view of what that credit concentration and credit risk was.

That’s what we were calling for regulation to do—to get information about all these counterparties’ exposures. Who was exposed to whom? It was obvious to me. We have this system of bank examiners—I don’t mean to disparage bank examiners, but they can be focused on the minutiae: “Are these forms being filled out correctly?” and they just miss the big picture of the big risk exposure and the functioning of a bank and its risk management. And the central banks allowing the capital to be set by the banks’ own internal models is just incredible.

TA: What would have happened had your recommendations been implemented in ‘94?

JB: AIG wouldn’t have happened.

TA: If AIG hadn’t happened—they were taking much of the super-senior risk and concentrating it in one place, you can follow it down the line, you would have much less lending to subprime housing, for instance. But you guys at that point were talking about interest-rate swaps:

JB: The credit-derivatives market was just being developed as we issued our report. We knew about it and we knew about AIG. Matter of fact, when you read about the regulatory gaps with the insurance companies, that’s what we had in mind.

We went up to meet with (CEO) Hank Greenberg up at his office at AIG to talk about our report and what we were recommending. He said “You can’t tell me anything about risk management. I’ve got control of this. It was out of control, but I’ve got control of it now. I have nothing to learn from you.”

The other thing that kills me—after our report came out and I was director of this group of about 120 people—some people in New York, Chicago, San Francisco—most in Washington. They did an amazing amount of work in the four or five years I headed that group. When Republicans took over the House, they cut GAO’s budget like 40 percent, partly I think as payback. They pretty much gutted the GAO’s ability to do this kind of work.

TA: Has it ever recovered?

JB: No.

TA: So if you were at GAO right now and were asked to do this kind of report you couldn’t do it?

JB: No, I don’t think you could do it, unfortunately.

One of the immediate fallouts from the big budget cut of the GAO was that we lost the New York office. I lost the people up there who helped do a lot of this work. I always gave them two directions: one, we want to be focusing on where the assets are—the big markets—and two, we want to focus on where the risk is. And that’s the way this derivatives report came about. It was growing rapidly, lot of exposure and big risk that no one was looking at.

TA: What do you think about how the press covers regulation?

JB: I think over the years the press, with a couple of key exceptions, the finance press is heavily influenced by industry. They take their side. To write their stories, financial reporters need to develop and maintain knowledgeable sources willing to speak on the record. These sources almost all come from the industry and naturally present the industry’s point of view. It is much more difficult for reporters to find informed, unbiased analysts willing to speak on the record. There is usually nothing in it for them to do so.

TA: Is the press more or less influenced than the regulators? Regulators from the last couple of administrations have identified with the industry and come from the industry…

JB: And this administration, too.

You get Larry Summers. You get Gary Gensler, who is actually the one who actively put in the deregulatory measure (Gensler, along with Phil Gramm, pushed the infamous Commodity Futures Modernization Act, which prevented the regulation of derivatives, most crucially the credit-default swaps that helped create the financial crisis). Then you’ve got their understudies. You’ve got Geithner. And then to take Geithner’s place at the Federal Reserve Bank of New York you get (William C.) Dudley. Well, Dudley is a former chief economist at Goldman Sachs.

President Obama needs to get away from this Wall Street-captured stuff.

TA: If the press identifies too much with the industry, what stories should it be doing now? What’s it missing?

JB: I think they’re concentrating too much on the proposals du jour without understanding or pointing out the fact that no one really understands what caused this financial collapse in this country and this incredible loss of wealth and this pain. And until you understand those causes you’re not going to be able to craft the correct solution.

But I don’t think the press can get at it. Unless you can get some examiner at Citigroup to talk on the record about “My God, we knew this place was a disaster, but Comptroller Dugan wouldn’t let us do anything about it.

TA: Which is unlikely.

JB: Extremely unlikely.

TA: Inside these agencies are people afraid to speak out?

JB: Oh, sure. You can pay a big price.

TA: How optimistic are you that the necessary reforms will be made?

JB: I think the same thing that happened (back in 1994), is going to be the same thing that’s going to happen now. The industry is already fighting back against anything really meaningful, but they’ll—as they did back then—they’ll form a study group and come up with some marginal stuff that won’t impinge upon their fees and upon their profitability. And that will be it.

TA: What should we be doing?

JB: This should never happen again—and it could have been prevented, actually. Congress should set up an independent investigative committee. Independent of members of Congress, and Wall Street, the administration, and the prior administration.

The commission I think ought to be created, ought to have subpoena power and available to them all the bank examination reports going back eight years for each of these large institutions that failed. They need to look at these examination reports. What was missed? Maybe it wasn’t missed. Maybe the examiners made recommendations up the line but they weren’t followed.

Let’s get to the bottom of this. What happened and why it happened? And let’s start identifying the failures) in corporate governance and why they occurred, the failures in risk management, and the regulatory failures and why they occurred.

TA: Well, what do you think happened?

JB: I think there are four main factors:

One, obviously, large financial institutions, systemically important around the globe, made bad investments. Over-concentration of risk, and there was too much leverage and inadequate capital.

Two, there’s gross failure in corporate governance at these institutions. Where were the boards of directors? Where was the senior management? Hundreds of billions of dollars in capital were wiped out in twelve to eighteen months.

Three, either inadequate risk management systems or failures of them at these institutions, most of which are very large sophisticated, heavily regulated institutions.

And four, regulators who were either not regulating—doing their job—or were told not to do their job. That’s the story that I think needs to be investigated and told. The OCC was on-site at Citigroup, for instance. They have very qualified competent people. Why weren’t they—maybe they were—why weren’t they identifying these exposures and these risks? Why weren’t they taking any corrective actions? Maybe they tried to and they were told not to.

TA: Nobody really came out shining in this whole thing. It wasn’t just the Republican Bush coming in saying “free markets.” Clinton was calling off the dogs to a certain extent, too. How directly were regulators/staff/lawyers told to either look the other way or be hands-off?

JB: Even in the Clinton administration, a lot has to do with the fact that the appointees to these regulatory agencies had profound connections to Wall Street. There’s always this presumption or this assertion that a Treasury secretary needs to come from Wall Street. I don’t think it’s necessarily a good thing for a Treasury secretary to be from Wall Street.

TA: Why not?

JB: Because they have potential conflicts of interest and because there’s the revolving door—they’re going to go back to Wall Street. That’s why. And one should really explore the incestuous ties between Goldman Sachs, the Federal Reserve Bank of New York, and the Treasury department over the past eight years. It’s about personnel; about the financial interests.

TA: How do you stop that revolving door? People say “well, you need to know what you’re doing.” If you haven’t been in the business you’re not going to understand how to regulate the business.

JB: I think you need more openness in the process. What you need to do is bring transparency to the regulators’ operation and make sure they’re politically accountable to elected officials.

That’s the problem with the Federal Reserve being a regulator. My position has changed about this. The reason is because they’re not politically accountable. They’re designed to be and should be independent in order to conduct monetary policy.

It’s also under the control of one individual, the chairman. A big part of what happened is that we had a Fed chairman who was chairman for so long and who was such a free-market ideologue that not only did he oppose any extension of regulation, when Congress gave him authority to set the terms for mortgages, he refused to follow it. And they’re secretive, they’re not transparent.

There needs to be reform of the Federal Reserve.

TA: I haven’t heard any discussion of that—except to beef it up. It’s a fundamentally undemocratic institution. For monetary policy, it may need to be, but when you expand powers for an undemocratic institution, that’s problematic.

JB: There can be conflicts of interest when you’re setting monetary policy and when you also have responsibility for supervising financial institutions because the direction of interest rates and the magnitude of change affects the financial condition of the people you’re regulating. Tremendous conflict of interest.

Chuck Bowsher, who was comptroller general at time (at GAO)—he deserves a lot of the credit for supporting this work—he used to have major regulators over for private lunches. Greenspan was a regular attendee and I’ll never forget the time he said—he did not believe in any regulation—but he also said “I don’t know why the Federal Reserve has regulatory authority over banks.” Truth be told, he wanted more because he didn’t want to use it.

Also, to show how extreme he was, I did hear him question the need for margin requirements in stock accounts.

TA: (laughs) Which is like let’s do 1929 all over again.

JB: Yes. I was just dumbfounded.

TA: Are you surprised that the press hasn’t circled back around to your report more? The ‘94 thing? There’s no institutional memory or something.

JB: Yes! Yes, I have been.

TA: Have you gotten called?

JB: No, not recently.

If you'd like to get email from CJR writers and editors, add your email address to our newsletter roll and we'll be in touch.

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.