Two key members of President Barack Obama’s economic team were part of a group of financial heavyweights that in the late 1990s helped to kill regulatory reform that might have limited the impact of the 2008 financial meltdown.
Now, as the administration’s primary proponents of free markets, they are again subverting efforts to tightly regulate trading activities and break up investment banks that are “too big to fail.”
According to a report on “Frontline,” a program broadcast by the Public Broadcasting System on October 20, current Treasury Secretary Timothy Geithner and Lawrence Summers, the Director of the White House Economic Council, were part of a group of free-market advocates that led a charge against proposed regulations to limit trading in over-the-counter (OTC) derivatives during the Clinton administration.
Those laissez-faire policies later led to a twenty-fold increase in the OTC markets over a ten year span – a house of cards that collapsed and spun the global economy into what is now being called the Great Recession.
The Frontline story raises new questions about Geithner’s role in financial regulatory reform at a time when he is already being criticized his continued ties to Wall Street and his inability to effectively manage the bailout at American International Group, Inc. (NYSE: AIG).
The questions come as the administration continues to reject calls to break up the biggest banks and investment firms long before they fail, or impose strict limits on trading the high-risk OTC derivatives and other “dark market” securities that largely precipitated the economic collapse.
The Wizard of Wall Street and His Acolytes Invade Washington
As Frontline reported, Geithner and Summers were both principal advisors, along with Federal Reserve Chairman Alan Greenspan, to Robert Rubin, President Clinton’s Secretary of the Treasury during the late 1990’s.
Greenspan, sometimes called the “Wizard of Wall Street,” is known as a financial libertarian vehemently opposed to government interference in markets. He first rose to power when he was named Chairman of the Federal Reserve Board during the Ford administration.
He and Rubin, who once ran Goldman Sachs (NYSE: GS) – along with former Harvard University professor Summers – were largely responsible for populating the Clinton administration with other free market acolytes, including Geithner.
The Frontline report examines how they formed a tight-knit alliance to shut down efforts by Brooksley E. Born, the Chairwoman of the Commodity Futures Trading Commission (CFTC), to regulate the secretive derivatives markets.
Born, who graduated first in her class at Stanford Law School in the early 1960’s, and spent more than 20 years litigating the OTC markets, rose to chair the CFTC after failing to secure an appointment to be Attorney General under Clinton.
At the time, the markets were flying high on the Internet boom and hardly anyone knew, or cared, about what Wall Street had labeled “The Black Box” — a $27 trillion market where banks operated in secret with no exchanges, no record keeping, and no public reports.
The lack of transparency led Born to wonder about the OTC markets.
“It puzzled me,” Born told Frontline. “What was it in this market that had to be hidden? Why did it have to be a completely dark market? So it made me very suspicious and troubled.”
But, according to the report, Greenspan warned Born against stepping up regulatory maneuvers. Incredibly, during an introductory lunch, Greenspan actually told Born that he didn't believe that fraud was something that needed to be enforced or was something that regulators should worry about – free markets could regulate themselves.
Later, Born had her staff issue a “Concept Release” publicly proposing a CFTC rule change to regulate the OTC markets. Rubin, Greenspan, and Arthur Leavitt, the Chairman of the Securities Exchange Commission (SEC), immediately launched a firestorm of criticism, issuing a statement condemning the release and lobbying Congress relentlessly to prevent her from initiating oversight.
“They were all part of a very concerted effort to shut her up and shut her down,” New York Times reporter Timothy O’Brien told Frontline.
Congress subsequently killed the initiative. A frustrated Born resigned shortly thereafter.
The Fallen “Rock Stars” of Wall Street
Meanwhile, a little known hedge fund had been attracting billions in investor money by using its own “Black Box” to quietly rake in fat returns. The creators of Long Term Capital Management (LCTM), known at the time as the “rock stars” of Wall Street, used proprietary formulas to rake in millions in trading fees.
With their sophisticated computerized trading algorithms, LTCM traders not only bagged huge profits, they bragged that their systems could strictly limit daily losses to a maximum of $30 million. But when the Russian currency crisis hit in 1998, LTCM suddenly began hemorrhaging money, losing $400-$500 million a day.
When large banks asked to collect on their collateral, they discovered that same collateral had been promised to other banks as well. Credit markets immediately locked up.
Facing a possible systemic meltdown, Rubin mobilized the Treasury department with emergency meetings to deal with a suddenly out-of-control “free” market.
Before the crisis was over, the government prevailed on 15 Wall Street banks to ante-up a total of $3.4 billion to bail out the hedge fund and settle accounts.
After the crisis was contained, an alarmed Congress once again held regulatory hearings, but Greenspan and his cronies again convinced them to drop the idea.
But Born, who had removed herself from the crossfire in Washington, clearly recognized the LTCM debacle as a familiar symptom of an unregulated market running amok.
“I thought that it was exactly what I had been worried about,” she said. “This was…gambling of a colossal nature. All these big banks had in essence … extended unlimited loans to LTCM, and they hadn't done their homework. They didn't even know the extent of LTCM's exposures in the market.”
Nevertheless, Congress failed to pass regulatory reform to address the problem.
A Ticking Time Bomb
Later, after Congress repealed the Depression-era Glass-Steagall Act, designed to keep investment activities segregated from typical banking functions like loaning money, the dark markets exploded.
Trillions of dollars of sub-prime mortgages, were sliced and diced together with investment-grade loans into murky collateralized debt obligations (CDO) that were insured by counterparties with credit default swaps (CDS) – something that the bankers and credit ratings agencies themselves didn’t fully understand.
The hands-off approach eventually inflated the OTC derivatives markets to $680 trillion worldwide in 2007 — 10 times the GDP of all the countries in the world.
As the economy collapsed, derivative products exploded all over the world, resulting in the seizure of credit markets and the bursting of the U.S. real estate bubble.
Reform Measures Still Lacking
As previously reported by Money Morninghas been derailed by lobbyists and cast aside by a Congress that is preoccupied with the heated debate over healthcare.
But while little progress has been made on regulatory reform, the banks keep rolling along, booking huge profits on the same risky wagers they were making before the financial crisis.
“We’re seeing the same kind of behavior from the banks, and that could lead to some huge and scary parallels,” Simon Johnson, former chief economist with the International Monetary Fund, told CNBC.
Geithner said Sunday he is planning to endorse a path before the House Financial Services Committee on Thursday that focuses on seizing control of troubled financial institutions and regulating them extensively before they can get themselves and the nation in trouble again.
The measure would make it easier for the government to seize control of troubled financial institutions, sack the management team, and wipe out shareholders. The administration still insists it will not separate commercial banking from investment operations.
But there is at least one top economist with Obama’s ear who says that is not enough.
Former Federal Reserve Chairman Paul A. Volcker has forwarded a proposal to roll back the nation’s commercial banks to the days of Glass-Steagal, when they were restricted to commercial banking and prohibited from engaging in risky Wall Street activities.
Volcker, arguing that regulation by itself will not work, says that the relentless pursuit of profits will eventually get the giant banks into trouble again.
Money Morning Contributing Editor Martin Hutchinson also thinks current reform efforts will prove futile. He recommends breaking up the big banks or putting restrictions on leverage as the only ways to keep them from taking on too much risk.
“Some of these banks are leveraging $50 million in cash into $500 million in credit. We’ve got to outlaw credit default swaps altogether or put limits on leveraging collateral. That may take some of the liquidity out of the system and make loans harder to get but so be it, if it reins these guys in,” Hutchinson told Money Morning in an interview.
For her part, former CFTC Chair Born calls the 2008 implosion “my worst nightmare come true,” and has no doubt about the dangers of leaving the banks to their own trading devices in an unregulated market that is still worth about $582 trillion.
“I think we will have continuing danger from these markets and that we will have repeats of the financial crisis, she said. “It may differ in details, but there will be significant financial downturns and disasters attributed to this regulatory gap over and over until we learn from experience.”
News & Related Story Links:
- Frontline: The Warning
- Money Morning:
Is Timothy Geithner A Roadblock to Regulatory Reform?
- Money Morning:
Obama’s Financial System Overhaul Would Give the Fed Broad Powers Over Wall Street
- Money Morning:
Wall Street Back to Business as Obama’s Regulatory Overhaul Loses Momentum
- Money Morning:
Here’s Why It’s Time to Ban Credit Default Swaps
credit default swaps
- New York Times:
U.S. eyes reining in ‘too big to fail’ institutions
- New York Times:
Volcker Fails to Sell a Bank Strategy