Sunday, September 16, 2018

The Financial Crisis of 2008 Part III: FINANCIAL WMDs

This seven-part series is excerpted from Chapter 8 of my book, Predicting the Markets: A Professional Autobiography.

CREDIT DERIVATIVES TURNED out to be weapons of mass financial destruction. They took off after the passage of the Commodity Futures Modernization Act of 2000. Once again, a key architect of the Act was Phil Gramm. His accomplices included Fed Chairman Alan Greenspan, Treasury Secretary Robert Rubin, Deputy Secretary Lawrence Summers, and SEC Chairman Arthur Levitt.[1] All four adamantly opposed what they viewed as a power grab by Brooksley Born, the head of the Commodity Futures Trading Commission (CFTC). In retrospect, her actions suggest she was guided not by power as much as by prescience and a strong moral code.

Born insisted that her agency should regulate the over-the-counter (OTC) credit derivatives market, which she wanted to see become an open exchange with strict rules, similar to the ones for commodities and financial futures. On May 7, 1998, the same day that the CFTC issued a concept release advocating her position, Rubin, Greenspan, and Levitt issued a joint statement denouncing her move: “We have grave concerns about this action and its possible consequences. . . . We are very concerned about reports that the CFTC’s action may increase the legal uncertainty concerning certain types of OTC derivatives.”[2] They proposed a moratorium on the CFTC’s ability to regulate OTC derivatives.

A few months later, during September 1998, Long-Term Capital Management (LTCM) blew up. The huge hedge fund had accumulated on a notional basis more than $1 trillion in OTC derivatives and $125 billion in securities on $4.8 billion of capital. The Federal Reserve Bank of New York orchestrated a bailout of the firm by its 14 OTC dealers, who had been clueless about LTCM’s enormous bets. This incident was a powerful indictment of the Rubin/Greenspan/Levitt position opposing tighter regulation of OTC derivatives and spoke volumes about the wisdom of Born’s initiative. Incredibly, in October 1998, Congress passed the requested moratorium on her proposal.

LTCM’s collapse should have been a victory for the CFTC’s view. Born said on November 13, 1998 that the LTCM debacle raised important issues about hedge funds and their increasing use of OTC derivatives—including “lack of transparency, excessive leverage, insufficient prudential controls, and the need for coordination and cooperation among international regulators.” She continued, “I welcome the heightened awareness of these issues that the LTCM matter has engendered and believe it is critically important for all financial regulators to work together closely and cooperatively on them.”[3]

That turned out to be Born’s swan song. Along with Greenspan, Rubin, and Levitt, Born sat on the President’s Working Group on Financial Markets, which was charged with recommending reforms in response to the LTCM debacle. But she resigned as CFTC chair in January 1999, leaving the group before its report was released amid what The New York Times called infighting that had deteriorated into a “fray.”[4]

The group’s report came out in April 1999, calling for new risk-reporting rules for hedge funds and others.[5] But its message was not long remembered. The working group’s next report, released in November 1999, did not recommend the regulation of derivatives that Born fought for—far from it. This later report suggested that Congress expressly exempt derivatives from oversight. Notably, it was produced after Larry Summers replaced Robert Rubin both as Treasury Secretary and on the working group, and after William J. Rainer had taken Born’s former job and place in the group.[6] Without Born’s advocacy, the notion of regulating derivatives died. The CFTC quietly withdrew its proposal.

The 2000 Act essentially prevented the regulation of credit derivatives. Derivatives products were deemed to be neither “futures,” requiring regulation under the Commodity Exchange Act of 1936, nor “securities,” subject to the federal securities laws. The Act’s rationale in exempting them from any specific regulation beyond the general “safety and soundness” standards to which the vendors of these products—banks and securities firms—normally were held by their federal overseers was that OTC derivatives transactions occurred between “sophisticated parties,” who presumably knew the risks they were undertaking. Therefore, the parties had no need for government protection; they watched out for themselves and kept each other honest.

The Gramm–Leach–Bliley Act of 1999 introduced the concept of functional regulation, a clever way of disempowering the regulators. This Act upended the system of regulatory checks and balances on the various special interest groups within the financial industry, replacing it with a divide-and-conquer system with respect to the regulators.[7] The 2000 Act simply barred financial industry regulators from any jurisdiction over credit derivatives. In effect, Phil Gramm’s invisible hand gave Wall Street carte blanche. The 2000 legislation introduced the concept of self-regulation by Wall Street, which was presumed at the time to be the next logical extension of functional regulation.

No one back then seemed very troubled by the fact that shortly after these two deregulation acts were passed in 1999 and 2000, Enron Corporation—a Houston-based energy, commodities, and services company—blew up. Gramm–Leach–Bliley had exempted from government regulation trades on electronic energy commodity markets, in a provision that later came to be known as the “Enron Loophole.” Exploiting this loophole, Enron had created the global market for energy-based derivatives. These customized risk-swapping contracts enabled parties to hedge their exposure to changing energy prices and supply fluctuations. Enron declared bankruptcy on December 2, 2001.

Wall Street’s investment bankers proceeded to ramp up the assembly lines in their credit derivatives departments that transformed trash into gold. The alchemy was enabled with collateralized debt obligations and credit default swaps (CDOs and CDSs). Here are some of the basics of these credit derivatives:

Slice and dice. “The CDO Machine” is the eighth chapter of The Financial Crisis Inquiry Report—released in January 2011 by the US government’s Financial Crisis Inquiry Commission (FCIC) and updated in February of that year. It is devoted to understanding the huge role that CDOs played in the financial crisis of 2008.[8] This chapter explains that CDOs are “structured financial instruments that purchase and pool financial assets such as the riskier tranches of various mortgage-backed securities.”

The tranches into which many MBSs are structured divide pools of mortgage debt into higher and lower credit ratings. Whatever losses result from defaults on the underlying mortgages (or other credit events) are absorbed by lower-rated (typically termed “equity” or “mezzanine”) tranches first, while the highest-rated (dubbed “senior”) tranches are the most sheltered from credit risks.

Wall Street piled the harder-to-sell lower-rated MBS tranches into CDOs, which were vouched to be sufficiently diversified that they were safer than their underlying MBS tranches. The credit rating agencies signed off on this sales pitch by giving AAA ratings to the vast majority of CDOs even though they consisted mostly of lower-rated MBS tranches. After all, the thinking went, these instruments were secured by a diversified pool of underlying assets that were very unlikely to go belly up at the same time. The problems began when this is exactly what did happen: the underlying securities’ performance started to correlate and, as the FCIC investigators wrote, “stopped performing at roughly the same time.”

Full menu. CDO products became more and more complicated. Some CDOs even had 80% to 100% of their assets in other CDOs, an instrument called “CDOs squared.” Compounding the complexity, financial services companies, including American International Group (AIG)—an American multinational insurance corporation—offered CDSs to CDO investors. CDSs, the FCIC explained, “promis[ed] to reimburse [investors] for any losses on the tranches in exchange for a stream of premium-like payments. This credit default swap protection made the CDOs much more attractive to potential investors because they appeared to be virtually risk free, but it created huge exposures for the credit default swap issuers if significant losses did occur.” There were also “synthetic” CDOs, which were “complex paper transactions involving credit default swaps.” The inquiry report concluded that CDOs, especially synthetic ones, worked to magnify the risk built up in the structured finance markets, multiplying the effects of the crisis. (See Appendix 8.2 in my book, Credit Derivatives: Basic Definitions.)

With so much easy credit available in the mortgage market, lending standards deteriorated rapidly and significantly. The FCIC reported, “Lenders made loans that they knew borrowers could not afford and that could cause massive losses to investors in mortgage securities.” Executives at Countrywide Financial Corporation, headed by Angelo Mozilo (on Time’s list of suspects) and the nation’s biggest mortgage lender at the time, realized as early as September 2004 that the loans they were making could result in “catastrophic consequences.” But they kept making more of them.[9]

Unregulated lenders jumped into the market. Many lenders no longer required down payments. Income verification was lax or nonexistent. Subprime mortgages jumped from 8% of mortgage originations in 2003 to 20% in 2005. The menu of mortgages expanded to include adjustable-rate mortgages (ARMs), interest-only mortgages, and payment-option ARMs. Lots of borrowers chose ARMs known as “2/28s” or “3/27s,” with low “teaser rates” for the first two or three years of their 30-year mortgages. Most of them turned delinquent as soon as they were reset at the market rate after the teaser period. (Again, see Appendix 8.2 in my book, Credit Derivatives: Basic Definitions.)

Orange County, California saw more than its share of unregulated lending companies sprouting up to meet Wall Street’s heady demand for mortgages to securitize, according to CNBC’s excellent special report on the financial crisis, House of Cards (first aired on February 12, 2009). People inexperienced and uneducated in banking were creating lending companies to get in on the action. Pizza boys were plucked from delivery trucks to become loan officers. Their only training was on the job—they learned to write mortgages by writing mortgages, according to the former head of such a company spotlighted in the documentary.

It was like the California Gold Rush all over again. For mortgage suppliers, the race was on to create more mortgages than the next guy. For their investment bank customers, the race was on to buy up more mortgage assets than the next guy and create more CDOs. Wall Street had discovered what seemed like a foolproof way to sell fool’s gold as real gold.

After the fact, all the lenders claimed that the loans had made sense at the time because everyone expected home prices to keep rising; almost nobody expected them to fall. For a short while, home prices didn’t just rise, they soared—along with home sales, financed by an orgy of mortgage lending that was facilitated by the securitization of mortgages.

Sometimes, cover stories in major magazines can be contrary indicators. This is the so-called “front-cover curse.” In 1997 and 1998, Rubin, Summers, and Greenspan worked with the International Monetary Fund and others to combat and contain financial crises in Russian, Asian, and Latin American financial markets; Time’s February 15, 1999 cover blared: “The Committee to Save the World: The inside story of how the Three Marketeers have prevented a global economic meltdown—so far.”[10] Ironically, their opposition to any regulation of the credit derivatives market and their support for the 2000 Act certainly helped to set the stage for the 2008 meltdown.

By the way, Brooksley Born got to have the last word on the subject, as one of the members of the FCIC. Not surprisingly, the commission’s report noted the irony of Time’s cover coming less than five months after LTCM hit the fan and three months after Congress buried the Glass–Steagall Act. The report took numerous direct swipes at Greenspan, Rubin, and Summers, not only for failing to stop the excesses that led to the financial crisis but also for helping to set the stage for it.


[1] See the US Commodity Futures Trading Commission Handbook.

[2] “Joint Statement” by Rubin, Greenspan, and Levitt, US Treasury, May 7, 1998.

[3] “Regulatory Responses to Risks in the OTC Derivatives Market,” Born’s November 13, 1998 speech.

[4] “Who’s in Charge? Agency Infighting and Regulatory Uncertainty,” The New York Times, December 15, 1998.

[5] Hedge Funds, Leverage, and the Lessons of Long-Term Capital Management, President’s Working Group on Financial Markets report, April 28, 1999.

[6] Over-the-Counter Derivatives Markets and the Commodity Exchange Act, President’s Working Group on Financial Markets report, November 9, 1999.

[7] “Securities Regulation After Glass–Steagall Reform,” SEC Commissioner Norman S. Johnson’s March 3, 2000 speech.

[8] The Financial Crisis Inquiry Report, specifically Figure 7.2 on p. 116, Figure 8.1 on p. 128, and Figure 8.2 on p. 144.

[9] The Financial Crisis Inquiry Report, p. xxii.

[10] Check out the cover of the February 15, 1999 issue of Time, featuring Robert Rubin, Alan Greenspan, and Larry Summers, and the corresponding article, “The Three Marketeers.”

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