What’s the Story With Regulating Derivatives?
Question: What’s going on with the just-announced regulatory reform of derivatives?
Paul Solman: Plenty. And you could say it’s about time. One of the leading scandals of recent years (and that’s no easy feat, considering how crooked a track it’s been) is the extent to which “laissez faire” turned first into “laissez loot” and, eventually, “laissez FAIL.” Nowhere was this more true than in the financial industry, which used its economic heft to influence the political process, resulting in a hands-off regulatory approach that amounted to what now seems like gross negligence.
Just one example, about which I’ve done some reporting over the decades. The Commodities Futures Trading Commission was a likely regulator of over-the-counter (OTC) derivatives. Once known for the kind of activism that foiled the Hunt brothers’ efforts to corner the silver market back in 1979, by the ’90s, the CFTC was in the hands of Wendy Gramm, wife of former Texas Republican Senator Phil Gramm, a devout free marketeer if ever there was one. The CFTC voted to exempt derivatives trading from regulation, including the kind of derivatives commodity trading Enron was specializing in. Among Wendy Gramm’s last acts as head of CFTC was the exemptions vote. Weeks later, she joined the board of Enron.
Throughout the ’90s, the CFTC was run by the Democrats, though. Head Brooksley Born wanted to regulate derivatives, especially the now notorious credit default swaps. (For an explanation of the swaps that we produced — and Jon Stewart mocked — go here.
But I do not mean this an anti-Republican tirade. The tenor of the times was anti-regulation. Congress saw things the financial industry’s way: Republicans and Democrats alike. President Clinton’s Treasury Secretary, Robert Rubin, and his assistant, Larry Summers, famously muscled Born to lay off derivatives.
Law professor Michael Greenberger was a CFTC lawyer in the late ’90s and here’s how he described the atmosphere to me:
“What happens is not a congressperson, but five different committees have hearings, call you up, ask you to testify, and scream at you for interfering with the free market system, that you’re slowing down the American economy by trying to get some transparency in this system.
The banks and the corporations are saying, “Hey, how can these federal financial regulators do this? We’re very sophisticated people. We don’t need to be regulated,” and nobody is arguing the other side. They’re making campaign contributions, left over right, every commissioner is getting visited by the lobbyists and the congressmen saying don’t do this, and in a booming economy, your hands are tied. And not only are your hands tied, but people are not reappointed to positions because they’ve been too aggressive in trying to make this argument.”
Laissez faire. Laissez loot. Laissez fail. And now, in the wake of the failure: RE-regulation. It looks good on paper. The proposal promises strict oversight, tight controls on leverage (debt), transparency. But one problem is what it might look like by the time it gets through Congress. Another: that the financial industry will always be a step ahead of those seeking to restrain it.
My friend and colleague on the Making Sen$e website, finance guru Zvi Bodie (whom I sometimes call Bodie-sattva), had this to say when I asked him to contribute an answer:
“I think that there is a need to consult with experts on the best way to regulate derivatives. Based on past financial reforms — for example, pension regulation— I have little reason to believe Congress will get it right.”
Personally, however, I’m more concerned that Wall St. will stay ahead of any regulation, however well intentioned and well crafted. I once talked to a guy about a story that I never wound up doing. It had to do with a maneuver in which shares of stock were converted into debt, which was then tax deductible. I wondered aloud if this was good for America.
“Hey look,” the guy said to me, “if you’ve got a problem with that, just end the tax deductibility of interest.”
“Oh yeah,” I scoffed. “That’s real easy to do!”
“It would be if you gave the job to me and six of my smartest guys. We’ll write the law in a few months.”
And then followed an exchange I’ve never forgotten.
“When you go back into private practice,” I said, “could you beat the law that you’d written?” His answer?
“I should certainly hope so.”
That said, regulation is an absolute necessity, in markets as in all human environments. It’s an eternal cat-and-mouse game. The regulators are usually playing catch-up. But if you simply stop playing, watch out.