5/25/10 11:36 AMMore on Clinton-Era Regulation of Derivatives - Grasping Reality with Both Hands

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Grasping Reality with Both HandsThe Semi-Daily Journal of Economist J. Bradford DeLong: Fair, Balanced, Reality-Based, and Even-HandedDepartment of Economics, U.C. Berkeley #3880, Berkeley, CA 94720-3880; 925 708 0467; delong@econ.berkeley.edu.

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More on Clinton-Era Regulation of Derivatives

James Kwak writes:

What Did Robert Rubin Think About Derivatives?: First Bill Clinton said he got bad advice from Robert Rubin onderivatives. Then a Clinton adviser issued a statement essentially taking it back and blaming Alan Greenspan. (JenniferTaub discussed some of the substantive issues on this blog.) Dan Froomkin asked Rubin, who said, “I thought we shouldregulate derivatives; I thought so when I was at Goldman Sachs and I thought so afterwards.” But Froomkin points out thatRubin was part of the team that suppressed Brooksley Born’s attempt to regulate derivatives back in 1998....

I think the fact of the matter is that we don’t know what Rubin thought about derivatives regulation in the mid-1990s,because somehow he managed to avoid making public statements about it at the time.... If Rubin did favor regulating OTCderivatives, why didn’t he do anything about it? That, to me, is the real question, not what Rubin may have thought in theprivacy of his own mind (or the privacy of the Oval Office)...

But I think we do know: I think Norman Carleton has it right:

Rubin had proposed to Born that, instead of the CFTC asking questions about the need for regulation of the OTCderivatives market, the President’s Working Group on Financial Markets issue the questions. Born point blank refused thissuggestion, thus pushing Rubin into Greenspan’s camp, much to the relief of ISDA and other Wall Street groups lobbyingon this issue. They knew they had a problem with Rubin. Brooksley Born was so sure she was right in her legal position thatshe could not compromise in face of the practical and political realities.... [S]he has been proven right and Greenspanwrong about the dangers of the OTC derivatives market.... [But h]istory might have been different if Born had agreed toRubin’s suggestion.

As I wrote before: As I understand things, Rubin's position on derivatives regulation in the late 1990s had five parts:

1. Derivatives should be regulated, with proper disclosure and capital adequacy and information requirements, especially toprotect unsophisticated investors.

2. Phil Gramm is Chairman of the Senate Banking Committee, and would always rather regulate less rather than more--andthe House side is even more so.

3. Brooksley Born and her organization are the wrong people to regulate derivatives.4. Derivatives should be regulated with a light hand, because they are a small and specialized corner of financial markets and

are simply not large enough to pose any systemic threat.5. The Federal Reserve has adequate powers to stem financial crisis and keep it from becoming a threat to the economy, and is

also not worried about derivatives.

As I see it, Rubin was correct on (1), (2), and (3). He was correct on (4) when he was in office--when derivatives were too smallto pose any systemic threat to financial stability. But that changed in the 2000s. And Rubin was completely, utterly, and totallywrong about (5) (as was I). One other place where Rubin was wrong in the late 1990s (and where I was right), was that he wasnot worried about the opacity of derivatives. He was confident that senior managers at large Wall Street firms could maintaincontrol over their derivatives books, and understand what risks their firms were facing, and what risks their underlings wereexposing their firms to. There he was wrong.

Let me now add a bit to that.

In the late 1990s, Phil Gramm and Jim Leach were chairmen of the Senate and House Banking Committees. They wanted toderegulate--and they had the votes to deregulate unless Clinton wanted to make it into an all-out war and assemble a coalitionto back a veto, which he did not. The Treasury's task--and Rubin's and Summers's task--was to figure out what smartderegulation would be, and nudge Gramm and Leach to that outcome. They failed. They failed to identify what smartderegulation would be. And they failed to nudge Gramm and Leach to that outcome.

Rubin and Summers, as I understand it, would both have preferred (a) lobbying Gramm and Leach to regulate derivatives witha light hand in a smart manner, but accepted (b) no regulation as an acceptable outcome, and preferred no regulation to (c)

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a light hand in a smart manner, but accepted (b) no regulation as an acceptable outcome, and preferred no regulation to (c)having Brooksley Born regulate derivatives at the CFTC in an incomplete, haphazard, and dangerous manner because of a lackof proper and complete legal authority. Brooksley Born, as I understand it, would rather (c) have regulated derivatives herself atthe CFTC under her current legal authority, but preferred (b) no regulation to (a) ceding some of the CFTC's power as part of aprocess of lobbying Gramm and Leach to regulate derivatives with a light hand in a smart manner.

Brad DeLong on May 01, 2010 at 04:00 PM in Economics, Economics: Finance, Economics: History, History, Politics |Permalink

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Cranky Observer said...> Rubin and Summers, as I understand it, would both have preferred (a) lobbying > Gramm and Leach to regulate derivatives with a light hand in a smart manner, > but accepted (b) no regulation as an acceptable outcome, and preferred no > regulation to (c) having Brooksley Born regulate derivatives at the CFTC in > an incomplete, haphazard, and dangerous manner because of a lack of proper > and complete legal authority. Brooksley Born, as I understand it, would > rather (c) have regulated derivatives herself at the CFTC under her current> legal authority, but preferred (b) no regulation to (a) ceding some of the> CFTC's power as part of a process of lobbying Gramm and Leach to regulate> derivatives with a light hand in a smart manner.

In other words, a turf fight: Rubin/Summers vs. everyone else, in which Rubin preferred that the playing field be nuked overhimself losing.

What exactly is it with these people who consider themselves The Smartest Man in the Room(tm)? Do they truly not know thatthey are not, in fact, the smartest person alive, and that even if they were (1) they could still be wrong (2) they could stillmisapprehend the situation (3) the situation could be of such scale any single human, or small faction, is too small tounderstand/control it?

But by all accounts, no, they don't know these things. And when the disaster happens they turn their Smartest Man powers (andmore importantly their social networks) to defending their actions.

Sickening.

Cranky

Reply May 01, 2010 at 04:33 PMAntonio Conselheiro said...What horrible bullshit. Rubin did the wrong thing because Ms. Born controlled his mind. She was mean to him and transgressedbureaucratic boundaries, so he had no choice but become a pimp for Wall Street and collaborate in the destruction of the worldeconomy. One and only one person is to blame for this disaster: Brooksley Born, who is lucky not to be in jail.

Reply May 01, 2010 at 04:57 PMchristofay said...The phrase "smartest guy in the room" is the tip that someone is going to get screwed. Unless you think you are the smartest guyin the room, then it's time to start heading to the door.

Surely another in a rearguard defense of the indefensible. Well, when Rubin had greater powers to distort the reality field thingsworked out great.

Oops, they didn't. Citibank is a ward of the state.

Rubins while at Citibank benefitted by the free Greenspan Put

The cost of having Rubinistas in the academia/wall st/fed gov merry-go-round moderate republican administration isresurrection of the republican party proper.

Reply May 01, 2010 at 05:21 PMbakho said...All this focus on Rubin is an attempt to shift any and all blame from GW Bush, A Greenspan, John Snow, Paulson and thegaggle of chainsaw wielding anti-regulation fools in the Bush administration.

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Derivatives during Rubin's tenure were a potential problem that did not need a lot of attention because they were relativelysmall. They became large enough to be worthy of attention under Bush. Bush let them blow up out of control.

No matter what deregulation was done under Clinton, Bush and his lock step GOP Congress had it in their power to place limits.Bush failed to do so. If Rubin was the Sec Treasury under Bush, then, maybe Rubin deserves more blame. Why are wescrutinizing Rubin and letting Greenspan, Snow and Paulson off the hook?

Reply May 01, 2010 at 06:01 PMmax said..."As I see it, Rubin was correct on (1), (2), and (3)."

Even if I concede 1 & 2, I do not concede 3. Born was prepared to regulate; Rubin was not. Rubin was offering to bury thepossibility of regulation in a committee, which is SOP for getting rid of troublesome bureaucratic initiatives. Born, OTOH, wasprepared to regulate and was unwilling to allow the measure to die in Rubin's committee so Rubin dropped the ball, probably(almost certainly) intentionally. Born had no choice but to insist on having the ball on her turf.

m, it's stinky

Reply May 01, 2010 at 06:13 PMAntonio Conselheiro said...http://blogs.reuters.com/felix-salmon/2010/05/01/blaming-rubin/

Who's letting Greenspan, Snow and Paulson off the hook? We're mostly just trying to figure out if there's anyone at all who'sinfluential and knowledgeable and doesn't have dirty hands.

Rubin and Summers (and Paulson) have a special importance because they're still in the driver's seat. We haven't evensucceeded in replacing the villains, never mind punishing them.

Reply May 01, 2010 at 06:17 PMAlex said...I don't agree with you about (4). Yes, derivatives back then were "too small to pose any systemic threat to financial stability",but that does not imply that it was right to decide to regulate them with a light-touch. Regulating them with a light touch iswhat allowed the derivatives market to get out of control and so pose a "systemic threat to financial stability".

Reply May 01, 2010 at 06:22 PMdilbert dogbert said...It would be interesting to hear a rebuttal from Born.

Reply May 01, 2010 at 07:02 PMbakho said...If derivatives would have been regulated back in the 90s, it would have been something else that blew up. Bush was hell bent onturning the banksters loose to do WTF they wanted. Instead of discussing Rubin and deregulation of derivatives, we would bediscussing Rubin and deregulation of something else.

Snow was a useful idiot who was put in place to ignore the lack of regulation and potential consequences. By 2005, the problemsbubbled up into plain sight. It still took Bush another year to get rid of the idiot Snow and replace him with Paulson to handlethe inevitable meltdown. In2005, the problems could have been unwound a lot easier than waiting for them to crash and burndown the road.

No matter what Rubin did or did not regulate, Rubin's actions could not have prevented the banksters from going wild underBush chainsaw regulation. Bush, the corrupt, What, me worry?, anti-regulator, left the store with the cash drawer open and thefront door unlocked. Bush is being let off the hook.

Reply May 01, 2010 at 08:57 PMRobert Waldmann said...You are now making claims stronger than Norman Carleton's claims. I am almost totally ignorant. All I know about his is what Iread in the post right here at this blog quoting him on Born Vs Rubin.Carleton did not claim that then existing law, principally the commodities exchange act (CEA) was not "proper and completelegal authority." Indeed he seems to have asserted that it gave complete legal authority to the CFTC to regulate all derivatives.The closest he came to doubting that Born had proper and complete legal authority to regulate derivatives was to note that herlegal interpretation had not been tested in court. This amounts to exactly the assertion that previous CFTCs had not chosen toregulate derivatives. He appealed not the the authority of the law (which he basically wrote then said what Born said it said) butto the precedent of Wendy Graham.

His objection to Born's proposal (and he comes very close to saying that he convinced Rubin to reject Born's proposal) was that,under Graham, the CFTC had granted hypothetical waivers which it clearly didn't have the power to grant. W Graham et al hassaid that they expressed no view on the question of whether they had the authority to regulated derivatives, that is whether theCEA applied to derivatives, but, if it did then they waived the requirement that the derivatives be traded on an exchange (the Ein CEA). According to Carleton, the CFTC definitely did not have the authority to grant all of the waivers which it granted,because some derivatives "total return derivatives" included claims on equity and the CFTC therefore did not have the authorityto waive the requirement that such derivatives trade on exchanges. This choice by W Graham et al, meant that, if the CEA wereinterpreted to mean what it clearly meant, outstanding contracts would have to be declared invalid.

Definitely according to Carleton the CFTC messed up when chaired by Wendy Graham not when chaired by Brooksely Born.That, and no limits to the propriety and copleteness of Born's claim of legal authority was the problem which worried him.

Anyway, this comment is pointless. I am summarizing from memory a passage from Carleton which is right here on this blog.I'll just say that your very serious accusation against Born receives no support at all from the legal authority which you cite asyou cite him. He had an objection, but it was completely different. His view was that when Republicans in positions of authority

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you cite him. He had an objection, but it was completely different. His view was that when Republicans in positions of authorityclaim the law says something it plainly doesn't say, it is wrong to say the law says what it plainly says, because that would bedisruptive.

Reply May 01, 2010 at 09:14 PMRobert Waldmann said in reply to bakho...What about the Grahams bakho ? Look Congress writes the laws. Phil and Wendy did it. For one thing look up what Carletonactually wrote as quoted here on this blog. Wendy Graham had made such a mess of things that allowing the CFTC to apply thelaw would have rendered outstanding contracts retroactively invalid. To avoid that, the law had to be changed, and P Grahamwould only allow it to be changed by deregulating derivatives.

Now I agree that Greenspan deserves even more of the blame. He had regulatory power. More importantly, back then he wasthe maestro and he used his immense reputation to advance Randian insanity.

Reply May 01, 2010 at 09:19 PMRobert Waldmann said in reply to Deja-Vu...Encore VuWell Deja it's still up there and it's 3:18 EDT May 2. I think you weaken your case with the great depression prediction. Theprobability is definitely going down and also well below 1 in 3 (I'd rate it well below one in a thousand frankly).

On Clinton you didn't mention three strikes and you're out.

On the death penalty you didn't mention Ricky Ray Rector, the guy he had killed who was so mentally handicapped that heasked if he could save part of his last meal "for later".

On the other hand, one thing that Robert Rubin, Barack Obama and Brad DeLong have in common is that none of them is BillClinton.

Reply May 01, 2010 at 09:34 PMRobert Waldmann said in reply to Antonio Conselheiro...Mr Maciel alias Counselheiro. Are you still a monarchist ? Do you still think alcohol should be banned. You know your projectdidn't work out so well. Also, by the way, the world didn't end soon after 1897.

Rubin was just one advisor of Clinton who clearly was determined to be at peace with Graham and Leach (they had oversightauthority related to Whitewater -- remember that ?). Rubin is not in the drivers seat. Nor is Paulson.

Has anyone noticed the curious incident of the DeLong who didn't bark in the night time ?

Reply May 01, 2010 at 09:46 PMAntonio Conselheiro said...Rather than argue about who is more to blame, relatively speaking, let's just guillotine about twenty of them. Probably we'llnever quite agree about, say, #15 through #25, but as long as we get the top five or ten most people will be happy with thisphase of the operation. We'll still be dealing with 10% unemployment, of course, and mere vengeance won't bring back a healthyeconomy, but it will cheer people up a little.

I just thought of an analogy. The AIDS epidemic was bad enough, but suppose that we had found that the medical professionhad played an active role in causing the epidemic, or that they had taken steps which made it much worse. (It is myunderstanding that this was not at all the case, and that except for smallish normal-range problems the medical professionperformed very well). In such a case, how we we feel about doctors afterward.

Reply May 02, 2010 at 05:22 AMKen Houghton said...I'm with Max on this one. The CFTC had experience regulating derivatives, had been working on the issue for years, and (3) isbasically b*llsh*t.

Indeed, as SvN has noted, (4) was clearly b*llsh*t by 1998 and LTCM--and most of the people who had been on one side or theother of the discussion since the late 1980s could tell you that matters reached critical mass for interconnectedness long beforethen. Since several of those people had occasion to speak to and with those agencies and regulators therein.

(If we want to be realistic about it, 1995 should have taught y'all about the power to disrupt markets.)

So it wasn't that the CFTC was the wrong agency--they were the ancestral home of derivatives regulation, however muchregulation may look like regulatory capture. They had and have the staff on hand who could understand the issues. And it wasn'tthat derivatives weren't a known problem--FASB had been working on what eventually became FAS133 since, again, the earlyand mid-1990s.

The most positive interpretation of your event chain is that Rubin wanted to grab some territory away from its rightful placeand expand his empire, and believed he could get cooperation from Phil Gramm et al. because when a Republican was nextinstalled, they would just eliminate any power the group had (if Rubin himself didn't plan to do that; remember, trying to spinRubin's slant positively here).

Reply May 02, 2010 at 08:14 PMAjay said...I am amazed, Prof. DeLong can not stand criticism of any Democratic administration economists. I remember his defense of L.Summers when he was appointed by Obama. I am sorry, "Grasping Reality with both hands"??? really, this blog site reads moreand more like DailyKos. And I am a liberal and someone who hates power and its exercise.

Reply May 02, 2010 at 08:45 PMbill n said...In response to Prof. D's previous post on this, I commented that 4) was the operative issue in derivative regulation in 1999. Istill think it was 4. -There was no CDS issue then.- By the time it was clear a CDS storm had hit, it was Snow's watch. -

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still think it was 4. -There was no CDS issue then.- By the time it was clear a CDS storm had hit, it was Snow's watch. -Impressive- eyebrows!

Ms. Born tried desperately to do something about the issue ex-ante, and resigned because she couldn't. She has rightly beengetting a lot of ex-post praise for her perspicuity. But, having resigned, in high and righteous dudgeon, she -assured- that shewould not be around when the storm hit, and thus when she might have actually been politically able to do something.

So... Bill's first rule of bureaucratic effectiveness: Always be clear about what outcome you want to achieve.

Reply May 02, 2010 at 09:35 PMchris said..."The Treasury's task--and Rubin's and Summers's task--was to figure out what smart deregulation would be, and nudge Grammand Leach to that outcome. They failed."

To be fair, the task as you have defined it is impossible. The only smart deregulation would have been no deregulation (and, infact, expansion of regulation to cover the shadow banking sector) and there's no way short of high explosives that Gramm couldhave been nudged into that position.

Reply May 03, 2010 at 06:02 AMTwofish said...1) Most derivatives trading takes place in London.

2) Most derivatives trading takes place in London because derivatives happen to be quite heavily regulated in the United States.In particular, there are pretty strict rules about who you can see derivatives to.

3) Historically CFTC has ended up regulating derivatives because CFTC has historically been looser about regulation than theSEC has. The CFTC has weaker much margin requirements than the SEC has, and index futures were first traded by the CMEbecause the SEC would not allow them.

I'm trying to figure out the relevance of any of this to what happened in 2008. AIG-FP was based in London. AIG-FP was basedin London because it couldn't trade CDS's in the United States. Tighter regulation in the US would not have changed anything.

It looks to me that people are just scoring political points and nothing else.

Also one problem is that there are quite a few different types of derivatives each with its own set of regulators. A lot of theproblem has to do with subprime mortgage securities that wouldn't have been subject to regulation by either SEC or CFTC.

Reply May 03, 2010 at 11:19 AMTwofish said...Also, I don't see what difference any of this would have made given that Bush got elected in 2001. The SEC has plenty of legalauthority to regulate derivatives. It didn't use any of it, and I don't see how moving things to CFTC would have made anydifference.

Reply May 03, 2010 at 11:30 AMzeno2vonnegut said...Ken and Max have the better arguments, but I will blather on anyway.

Addressing point 3, as a non-lawyer if I were to need advice on a legal question involving the application of the CommoditiesExchange Act to derivatives trading I would not ask Summers or Rubin or most especially Greenspan. From Wikipedia onBrooksley Born: "She developed a practice representing clients in numerous complex litigation and arbitration cases involvingfinancial market transactions. ... She made partner at Arnold & Porter and eventually rose to be the head of the firm'sderivatives practice." If Rubin and Summers thought that "Brooksley Born [would] regulate derivatives at the CFTC in anincomplete, haphazard, and dangerous manner because of a lack of proper and complete legal authority" then Brad Delong hasscored an own goal -- in my opinion. If there were a more knowledgeable person in the government on this issue than Born Iwould be surprised and Rubin and Summers should have realized this.

With regard to point 4, even if LTCM had not exposed the existential danger posed by derivatives, not regulating a marketbecause it's small both exposes the innocent to being fleeced even if they lose only a few hundred billion dollars and encouragesthe unscrupulous to flock to this market until there's some real money to be taken.

With regard to point 5, the Fed and Treasury have had more power than they have exercised. The most important Fedconstituency is not the average citizen and protection of the average citizen has not been on their radar.

Reply May 03, 2010 at 03:20 PMTwofish said...zeno2vonnegut: If Rubin and Summers thought that "Brooksley Born [would] regulate derivatives at the CFTC in anincomplete, haphazard, and dangerous manner because of a lack of proper and complete legal authority" then Brad Delong hasscored an own goal -- in my opinion.

I'd argue the opposite. The job of high power lawyers in big legal firms is to take the law and pushing it in a new original andspeculative directions. If you are using settled boring interpretations of the law, then you don't need a particularly good lawyer.If you are a ultra-good lawyer, I think the temptation to push the law would be a lot higher than if you aren't a lawyer at all.

The problem is that if you are a lawyer in a firm and you go with an original and speculative interpretation of the law (usuallybecause you are going to lose anyway if you don't) and you lose, the consequences are much, much smaller than if you are thehead of an agency.

zeno2vonnegut: If there were a more knowledgeable person in the government on this issue than Born I would be surprised andRubin and Summers should have realized this.

A lot of securities law is not about knowledge, but about creativity. The written laws themselves are extremely vague, and muchof what happens boils down to what you can convince a judge to allow.

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Me: Economists:

Paul KrugmanMark ThomaCowen andTabarrokChinn andHamiltonBrad Setser

Juicebox Mafia:

Ezra KleinMatthew YglesiasSpencer AckermanDana GoldsteinDan Froomkin

Moral

Philosophers:

Hilzoy and FriendsCrooked Timber ofHumanityMark Kleiman andFriendsEric Rauchwayand FriendsJohn Holbo andFriends

of what happens boils down to what you can convince a judge to allow.

Reply May 03, 2010 at 08:07 PMzeno2vonnegut said in reply to Twofish...Creative is not the first adjective I would associate with a good lawyer; successful is. Twofish suggests as a metric "what you canconvince a judge to allow" which is part of it and another part is issuing advice that minimizes the chance of a judge becominginvolved. Born's rise to head of practice indicates to me that she was a very successful lawyer. Born being the first woman to editthe Stanford law review clearly shows her preeminent intellect. I'll stand by my statement that the boys' team wrongly dismissedher expertise.

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