Don't get fooled again
Revisiting the lessons from deregulating derivatives is particularly important right now because Congress seems to have forgotten them. A report we issued Monday provides a road map of how derivatives wrecked the economy in 2008, and could do so again if Wall Street gets its way.
Nine bills that would roll back the derivatives reforms created in the wake of the financial crisis are moving in Congress. These proposals, most of which have at least passed in committee, have been put forth in the name of furthering the competitiveness of U.S. companies and aiding Main Street job creation. These are quite brazen claims, since deregulating derivatives arguably did more to harm economic competitiveness and job creation than anything Congress has done for a very long time.
Here is the history, in brief: At the end of the Clinton administration, financial derivatives were relatively new and sat in a regulatory netherworld. In practice, they were not regulated. But they bore all the hallmarks of traditional futures, which by law must be traded on regulated exchanges.
Federal Reserve Chairman Alan Greenspan and successive Treasury Secretaries Robert Rubin and Lawrence Summers (a trio Time magazine dubbed The Committee to Save the World in 1999) argued that financial derivatives investors were too “sophisticated” to require oversight. Regulating derivatives would “cause the worst financial crisis since World War II,” Summers expanded.
In 2000, with the passage of the Commodity Futures Modernization Act, Congress established a regulation-free haven for financial derivatives. Derivatives soon became a petri dish for the growth of financial risk-taking, especially relating to the housing market.
In rough terms, derivatives’ dealers sold hundreds of billions of dollars’ worth of quasi-insurance policies (called credit default swaps) on mortgage-backed securities to holders of the securities. The illusion of protection provided by these insurance policies helped create a voracious appetite on Wall Street for mortgages to bundle into securities. This, in turn, led mortgage originators to adopt laughably low underwriting standards, causing housing prices to soar to unsustainable levels.
When reality intervened and mortgages defaults began occurring in droves, holders of defaulted mortgage-backed securities submitted claims to the provider of their credit default swap “insurance policies” (primarily American International Group, or AIG), only to learn that AIG could not make good on its promises. The absence of supervision of derivatives had permitted AIG to amass risks well in excess of its resources—and thereby put the entire economy in grave jeopardy.
AIG’s inability to pay its counterparties threatened to cause a ripple effect of institutional failures that could have thrown the economy back into the stone age. A $700 billion taxpayer-funded bailout was ordered up to prevent a total collapse of the financial system. Regular Americans were left to suffer through the deepest recession since the Great Depression.
Experts agree with the essence of the summary above. Each of the members of The Committee to Save the World, for instance, has recanted his advocacy for a laissez-faire approach to derivatives. Rubin now says he even favored regulation when critical decisions were being made in the late 1990s, but that “very strongly held views in the financial services industry in opposition to regulation were insurmountable.”
Which brings us to the present. The Dodd-Frank Wall Street Reform and Consumer Protection Act instituted a series of common sense reforms, including requirements for derivatives trades to occur on designated exchanges. This key step would ensure that prices are transparent and that a centralized clearing agency guarantees the credit worthiness of trading participants. This is how stocks and futures have been traded since the reforms of the 1930s. But because more money can be made trading on opaque, unsupervised markets, Wall Street objects to this reform. Once again, its leaders are attempting to subject Washington, and the country, to an insurmountable force.
Of the bills seeking to punch holes in Dodd-Frank, a few are comically ridiculous—and dangerous. One, H.R. 3283, cedes regulatory authority to foreign governments for the overseas activities of U.S. firms. Ask yourself, when was the last time Congress advocated submitting to foreign control of anything? Only Wall Street’s influence could convince lawmakers to favor such a thing.
Another bill is the cleverly titled Swaps Bailout Prevention Act. It does the opposite of what its title suggests. It would repeal Dodd-Frank’s prohibition against bailing out of major derivatives participants and, thus, allow federally insured banks to remain major derivatives players.
Last week brought news that JPMorganChase, the nation’s largest bank, suffered losses of at least $2 billion—which may climb above $4 billion—on bets on credit default swaps, the same scourge that led to the 2008 crisis. More alarming, the bank’s losses came on positions that may have been as high as $100 billion, meaning that a slight change in conditions had potentially enormous implications. This is exactly why derivatives, which financier Warren Buffett presciently labeled financial weapons of mass destruction in 2003, require vigilant public oversight.
The JPMorgan episode may be the warning that Congress needs to return to its role of protecting the public rather than coddling the banks. But it also raises a question: how many times does a lesson have to be taught before it is learned?