The Audit wants to know. What role did the press play in diffusing financial warnings in the years leading up to the current crisis?

We can’t answer that question in its entirety—especially not in one post—but we can offer an example for your consideration: the press’s supremely insufficient response to an important 1994 report by the Government Accountability Office, the investigative arm of Congress, warning about the dangers of derivatives—those largely unregulated financial instruments that have played such a central role in the current collapse.

The two-hundred page report, two years in the making, could have resulted in tough derivatives legislation, which is to say needed regulation. But it didn’t. The reasons why are complicated, and the press is certainly not the only culprit here, but it did play a key role. What happened is this: A triumvirate of the financial industry, misguided regulators and a passive press relegated the report to the dustbin almost as soon as it came out.

(UPDATE: A few months after this piece, The Audit interviewed James L. Bothwell, the author of this critical report. Read it here.)

This despite the fact that the report was remarkably prescient in its strong warning about derivatives—almost a decade before Warren Buffet’s now-famous derivatives-as-WMD comment.

The report does not entirely condemn derivatives, but it is full of flashing danger lights. First it offers some context:

Derivatives activities are rapidly expanding and increasingly affected by the globalization of commerce and financial markets. 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.

And then the warning comes:

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.

But that’s not all:

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.

Bailout. Paid. For. By. Taxpayers. The GAO didn’t have a crystal ball. It just did its job, which was to look at the facts. And after two years analyzing the situation, the GAO had earned the right to offer warnings. But the resulting work was unfairly dismissed—to all of our detriments.

Speaking of dismissal, that phrase “financial bailout paid for by taxpayers” was later derided in the press as a scare tactic. We’ll get to that in a moment, but first let’s finish with the report, which went on to offer some pretty straightforward guidelines:

The immediate need is for Congress to bring currently unregulated OTC derivatives activities of securities firm and insurance company affiliates under the purview of one or more of the existing federal financial regulators and to ensure that derivatives regulation is consistent and comprehensive across regulatory agencies.

And then the ambitious document broadened its scope:

GAO also recommends that Congress systematically address the need to revamp and modernize the entire U.S. financial regulatory system. Gaps and weaknesses in OTC derivatives regulation clearly demonstrate that the existing regulatory structure has not kept pace with the dramatic and rapid changes in the domestic and global financial markets that have occurred over the past several years. Banking, securities, futures, and insurance are no longer separate and distinct industries that can be well regulated by the existing patchwork quilt of federal and state agencies.

We don’t need to tell you that this analysis couldn’t have been more right.

As for methodology, the study included a survey of 14 major U.S. OTC derivatives dealers, chosen because they had “the highest levels of derivatives activity in their respective industries.” (A fifteenth refused to respond.) The list: Bank of America, Bankers Trust Co., Chase Manhattan, Chemical Bank, Citibank, First Chicago, General Re, Goldman Sachs, JP Morgan, Lehman Brothers, Merrill Lynch, Morgan Stanley, Prudential, Salomon Brothers.

This is a pretty comprehensive list of the current crippled or dead.

By way of context, the GAO study came at a time of concern over derivatives and wasn’t the only of its kind. It followed other significant reports, including two in 1993: one by the Group of Thirty and one by the Office of the Comptroller of the Currency along with the Federal Reserve. But the GAO, while nodding to these efforts, essentially called them inadequate.

As we just mentioned, it is hard not to notice that industry executives, regulators and the press often seemed to work in concert. But we want to clarify that point: We aren’t making conspiracy accusations here, we are just saying that regulators and industry executives by and large took the same anti-regulatory line—and then the press chose to pass along these thoughts rather than examine them.

Let’s start by looking at the, rather predictable, industry reaction to the report.

The GAO report so worried industry executives that they took aim and fired before it even came out. A February 17, 1994, Reuters piece, headlined “U.S. study sparks fears in derivatives industry,” told us:

Derivatives players and authorities alike are growing edgy about a planned report by the U.S. General Accounting Office (GAO), bankers and officials said.

Then:

Amid increasing publicity of the potential risks from derivatives’ alarming growth, many fear the report will recommend unnecessary or unwieldy regulation.

‘Some are concerned that the GAO report could be used as a predicate for legislation of the market,’ said one market authority attending the conference.