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Lessons Learned...or not
A few weeks ago, I noted a PBS “Frontline” program on former Commodity Futures Trading Commission (CFTC) head Brooksley Born, who in the 1990s became alarmed by the lack of oversight of the shadowy over-the-counter derivatives market. But her attempts to regulate it were beaten back by then Federal Reserve Chairman Alan Greenspan, then-Treasury Secretary Robert Rubin and then-Deputy Treasury Secretary Larry Summers. Born then resigned June 1999. Following are some excerpts from an interview Born did with “Frontline” this past August 2009. It has everything to do with the current debate in Congress over the need for regulation of our markets.
Frontline: So let’s start with September 2008 as we all sat there and watched the economy melting down and heard about things called credit default swaps (CDS). It wasn’t the first time you’d heard of these sophisticated financial instruments. What did you think when you were watching it happen?
Born: It was like my worst nightmare coming true. I had had enormous concerns about the over-the-counter derivatives (OTC) market, including credit default swaps, for a number of years. The market was totally opaque; we now call it the dark market. So nobody really knew what was going on in the market.
And then it became obvious as Lehman Brothers failed, as AIG suddenly appeared to be on the brink of tremendous defaults and turned out had been a major credit default swap dealer and needed hundreds of billions of dollars to keep it alive, the contagion in the marketplace from those failures brought many, many of our biggest financial services companies to the brink of collapse. And it was very frightening.
Frontline: How did it happen?
Born: I think it happened because there was no oversight of a very, very big, dynamic, growing market. Market participants don’t look out for the public interest. Traditionally, government has had to protect the public interest by overseeing the marketplace and keeping the extreme behavior under some check.
We had no regulation. No federal or state public official had any idea what was going on in those markets, so enormous leverage was permitted, enormous borrowing. There was also little or no capital being put up as collateral for the transactions. All the players in the marketplace were participants and counterparties to one another’s contracts. This market had gotten to be over $680 trillion in notional value as of June 2008 when it topped up. I think that was the peak. And that is an enormous market. That’s more than 10 times the gross national product of all the countries in the world.
Frontline: This was something that you discovered, heard about, came across, back in the mid-1990s?
Born: Yes. When I was chair of the CFTC, I became aware of how quickly the over-the-counter derivatives market was growing, how little any of the federal regulators knew about it.
And also, we were seeing some very dangerous things happening in that market. There were some major fraud cases. There was use of OTC derivatives to manipulate the price of commodities. And there were some spectacular failures by institutions that were speculating in the over-the-counter market with little or no restraint. For example, Orange County, Calif., was brought down, went into bankruptcy because of its speculation, gambling with public money in the OTC derivatives market on interest rate swaps.
I became very concerned. This market had been under the jurisdiction of my agency and had been expanding for about three years when I came into office because one of my predecessors had led an effort to exempt these transactions from a requirement of exchange trading. So, by an exemption, the commission had permitted the OTC market to grow. And in the few years, three years, it had grown to something like $25 or $30 trillion in notional value….
And the astonishing thing, at least for me as I began to learn about this, was nobody in government knew how much, how big, where, who the parties were, at all.
That’s correct. None of the other financial regulators knew about it, either. And it seemed to me we all needed to know. There needed to be some light shone on this market so that we knew what kind of risks might be being created there.
We knew who the participants were. We did know that our biggest banks and investment banks were the dealers in the market, and that they were being very profitable in their dealing in the market.
Frontline: But who the buyers were, what the deal was, the spreading of the risk, was still, as you say, opaque?
Born: We just didn’t have the information….
Frontline: What was the danger to the public that you were concerned about in the over-the-counter derivatives market?
Born: First of all, we didn’t truly know the dangers in the market because it was a dark market. There was no transparency. But generally, in any financial market, if there is not government oversight to control abuses like fraud and manipulation, to limit speculation, to make sure that a major default won’t cause a domino effect throughout the economy, the public interest is exposed and in danger.
Beyond that, and perhaps on a more specific level, I knew that the entities participating in the market were ones that all the people actually had interest in. They were the companies that people had invested in; they were the employers of many people; they were the pension funds for many retirees; they were the insurance companies for many people who were depending on those companies for their insurance. So I knew that all the people had an investment in stability in that market….
I was also aware that there had been some spectacular failures, collapses, by speculators in the market and that big institutions and a broad range of companies – from pension funds to public entities like Orange County to corporations – were speculating in the markets. But I did not have any idea of the size and complexity that the market had arrived at until I got to the CFTC and my staff began to say how big this was and how little information they had about it….
Frontline: People said: “Wait a minute, these are consenting adults in a swap, in a derivative deal. As sophisticated investors, they don’t need regulation to protect them.” Is what Orange County represents that maybe people are not sophisticated?....
Born: These are very complex instruments, and the way they work is pretty complicated. Highly sophisticated computer models are used by the OTC derivatives dealers to figure out values and the circumstances under which they would profit highly and the counterparty would lose. And those tools weren’t available to the other parties, what we then called the end users of the over-the-counter derivatives.
The other aspect of this was it may well be that Orange County was a big, sophisticated entity; let’s assume it was. But it was using the taxpayers’ money, so every single taxpayer in Orange County lost when Orange County lost. And it was the public interest that I was mostly interested in, not so much the particular interest of individual players in the market.