What If They Had Listened to Born on Regulating Derivatives?

Harvey Pitt Chair, Securities & Exchange Commission (2001-2003)

My sense is that, given the lack of government expertise in these markets, the likelihood is that even had there been regulation, it would not have been able to prevent the kinds of catastrophic events we've now seen.

Because?

Because there's a lack of real understanding on the part of the people who have to create the regulations, for one thing.

You mean it's just too sophisticated?

It's not that people in the government aren't sophisticated or can't deal with sophisticated problems. It is that government is always a light-year or two behind the marketplace. It's the marketplace that creates, that has ingenuity and so on. Government spends a lot of time catching up.

And part of the difficulty, and we see that even today, is that government's response when things go wrong is usually to try to fix the last crisis instead of preventing the next crisis. And the situation with OTC [over-the-counter] derivatives is sort of a cautionary tale about the way regulation ought to be evolving and adopted, as opposed to the way it looks like it will actually evolve and be adopted. …

Joe Nocera The New York Times

There is no way of knowing. It is a giant hypothetical. … It is certainly possible that the crisis could have been avoided if Brooksley Born had been able to regulate derivatives. It is possible. It is also possible that 10 years later the CFTC [Commodity Futures Trading Commission] would have proven as inept as the SEC was in finding Bernie Madoff, you know?

So she had a powerfully good impulse. She was right on the merits. It might have made a difference, but we will never, ever know. …

Joseph Stiglitz Council of Economic Advisers (1993-1997)

I think to understand the crisis of 2007, 2008, 2009, you have to understand that it had many, many sources, many, many factors that contributed to it. The underlying recklessness of the banks, their perverse incentive structures, the fact that they were too big to fail encouraged them to engage in excessive risk taking; meant that if you had tied their hand in one direction, it's likely that they would have moved in another direction.

But it's absolutely clear to me that if we had restricted the derivatives, some of the major problems would have been avoided. Some of what it has cost American taxpayers -- a great deal would have been avoided.

I think there is a very high probability, for instance, that we would not have had to pay out the hundreds of billions of dollars that have gone to AIG, that much of the other financial turmoil we would have avoided.

But we still would have had the problems of the mortgages; we still would have had the problems at rating agencies.

So I think it's too simplistic to say that if we had done this one thing, we would have avoided the crisis. ... I view her experience as a dramatic illustration of what was wrong with the system and the power of the financial markets to resist doing what should have been done. But they did it with predatory lending; they did it with mortgages; they did it in area after area. And it would have needed a comprehensive attack to stop that.

Mark Brickell Chair, International Swaps and Derivatives Association (1988-1992)

If the concept release and the review of policy that was precipitated by the release had reached a different conclusion, the results would have been problematic for the financial system, because if the conclusion was that these contracts should be regulated by the Commodity Futures Trading Commission, they would have to be futures contracts in order to fall within the scope of the CFTC's authority. And if they were futures, then some portion of $80 trillion in notional principal amount would have been entered into illegally, and the contracts would have been unenforceable.

So it was potentially a cataclysmic event for the banking system and for corporate America relying on the hedges that had been provided by the banks. If all those contracts had been torn up, it would have caused many losses. It would have been hard to determine where those losses would fall, but certainly it would have been of great difficulty to the banking system, and therefore to the financial system as a whole.

David Wessel The Wall Street Journal; author, In Fed We Trust

It's easy to look back on the things that we didn't do and the problems that were caused. No one ever gets credit for the things that get fixed and then didn't blow up.

One thing that did come during the 2000s -- partly as a result of some of the stuff that happened at LTCM -- was the Federal Reserve Bank of New York was horrified to discover that a lot of this trading in derivatives and credit default swaps was being done in a very old-fashioned, sloppy manner. The paperwork was a mess, and there would be days between the day that you sold something and that the other guy who bought it acknowledged that he had bought it.

They were worried that if you had a problem and the merry-go-round stopped, there would be a lot of disputes about who had done what to whom. And so they actually did clean that up.

We had huge problems. We made enormous mistakes. [But] it could have been even worse, hard as that is to believe, if there had been this paperwork problem.

And the one thing -- maybe the only thing -- that the Federal Reserve Bank of New York under Tim Geithner actually did that we saw had some effect was to get all these guys to say: "OK, you've got to have a modern financial back office here. We can't have the situation where huge percentages of your trades are unconfirmed and stuff."

So it's not like nothing happens after LTCM; it's not like nothing happens after Enron -- it's just we didn't seem to fix the fundamentals. We fixed some of the minor problems.

… It's this black box -- trades are happening, and people don't know. At LTCM, what happened was banks that thought they were the only lender discovered there were 13 other guys in line, right?

Right.

And said: "Oh, my God, if only I would have known, I would have given less. The leverage wouldn't have been as bad." [The argument was] that if you could get at least an exchange going, you might know.

Right. Another piece of evidence in support of the case that Brooksley Born identified something that was, in fact, a problem is to look at what [Chair of the National Economic Council] Larry Summers and [Treasury Secretary] Tim Geithner are proposing today as a result of the Great Panic of 2007 and 2008.

They are proposing that more derivatives be traded on exchanges, and that if you play in this game you have to have what they call margin. You have to put something up, so you can't just bet without having anything on the table.

And so, in some respect, those are things that a rational conversation of the Brooksley Born concept paper might have produced.

But the circumstances have changed a lot. The market's a lot bigger, and the dangers are not theoretical.

She was talking about something that she suspected was a problem, but it wasn't yet a problem. Now we see there were things that she identified that did become problems and we're trying to fix them. It is, of course, human nature that it's hard to fix a lot of problems before they're problems. And she will become a case study in that.

Sheila Bair Chair, Federal Deposit Insurance Corporation (2006-present)

What if Brooksley Born had been listened to? …

You never know for sure. I think there could have been a significant difference. A lot of this, it doesn't take a terrible lot. For instance, transparency. The credit default swap [CDS] market -- even a regulator cannot know. If I want to know who holds all the CDS positions on Bank X -- so they're betting that Bank X may go down -- as chairman of the FDIC, it'd be kind of helpful information to know who out there has got an interest in a particular bank going down.

I can't get that information right now. We're working on it. The regulators are working together to try to get all that information in the same place, and allow us to access it. But the fact that no regulator can get it right now, and the people who are taking those positions know that, there's really no chilling effect that we might otherwise have if they know that the SEC or the FDIC or the Fed or whoever knows what kind of positions they're taking, how big their positions are, how frequently they're changing them, can match them up against whether they're maybe short the stock.

Just having that kind of information and transparency can have a very good dampening effect on high-risk, speculative or potentially manipulative behavior. So that is doable, you know?

And I think probably if we had done just common-sense steps like that in the late '90s or even earlier, we could have curbed a lot of this excessive risk taking. But we didn't. They were very opaque markets, still are. But we're working on it.

Roger Lowenstein Author, When Genius Failed

This meltdown had many fathers. You can't pin this all on Brooksley Born's opponents. You can't pin it all on the Federal Reserve. You can't pin it all on the credit rating agencies. You can't pin it all on dumb, greedy bankers. You can't pin it all on dumb or dishonest mortgagees, homeowners, lying on their applications. All those parties played a hand.

All you can say is, had restraint been exercised, as she urged, there would have been a little less. Had the credit-rating agencies done a little better job, it would have been a little less, so on down the line.

But you've got 15 million people out of work -- you can't pin it all on one meeting with Brooksley Born.

Can you pin it all on this idea of deregulation being next to godliness?

Yeah, I think it's less a matter of Brooksley Born exclusively, or exclusively the lack of regulation of mortgages, or of allowing investment banks to combine with commercial banks -- it's this religion that swept through markets and swept through Washington, that whatever bankers wanted to do was a good thing, no questions asked.

If we could have braked that religion, I think we would have had a much less serious situation.

Timothy O'Brien The New York Times

I don't think people can dismiss good management and good regulation. Would Citigroup have been a different bank if it had different management? Certainly. Would it have not blown up if it had other people managing it? Certainly.

Does the regulatory system depend on quality people making the right decisions and trying to enforce what is on the books and making sure you put stuff on the books that needs to be there? Does that make a difference? Absolutely.

Had Brooksley Born been enfranchised, had Brooksley Born been listened to, had Brooksley Born been made part of the process, would that have had a different ending for what subsequently happened in the derivatives market? Certainly.

Certainly?

Sure. If people actually empowered her to do some of the things in the derivatives market that she wanted to do -- which, by the way, are some of the things they're advocating right now at the White House -- put these things on an exchange of some fashion and make sure there's greater transparency around them; there's a big debate right now as to whether or not the White House is actually going far enough in that regard.

But certainly there would have been a different world financially if people in the late '90s had taken Brooksley Born more seriously and had looked at potential problems in derivatives and had responded in a regulatory fashion that made since. Sure, the world would have been very different.

Ron Suskind Author, The Price of Loyalty

History is a complex dance, and it's hard to map causations. It's hard to say if this had happened, then that would have been the result, or a thing wouldn't have happened.

I think that the key thing that is really at stake here is something that seems part of the horse-and-buggy department in this era of message, this era of power having its way in so many parts of American life. It is this idea of trusting truth. People don't, certainly in the public space.

Let's ask ourselves hard questions. Why is it we think this thing? Is there anything here that's hard data, facts? What is it we've learned? Even if it means that somehow it won't be as easy going forward, we'll have to think again and come up with new innovations, new thoughts, new clarity and understanding.

And this is another example where Brooksley steps up, says something that does scare the bejesus out of everybody. But, at that point no one really stops and says: "Wait a second. What exactly is she saying? This is not about what I'm getting paid this year. This is not about what I said a few years ago that I'll be challenged with now if I contradict it. This is really about trusting truth." …

And I think the lesson going forward is that when moments like this occur, even though there's a great desire to attack the skunk at that garden party, to get rid of it, to say: "You got a party going on here? What are you talking about? Who gave you an invitation to this party?," instead we say, "Well, if somebody has the temerity to step up and say, 'I have a position that is supported by real facts; let me please show them to you,' that people will stop and think and listen." And I think this is a case where we didn't do that.

Daniel Waldman General counsel, CFTC (1996-1999)

My feeling was that it really was a product of the times. There are way bigger forces involved. If you lived through the '90s and the early part of this decade, you just saw very strong faith in our financial institutions and in markets, and very little interest, both by policy-makers and folks within the government, to have active government involvement.

So I never felt like, well, if they just listened to us that the world would have changed. There were very big forces at work that made what happened I guess in some way inevitable.

You mean, even if you would have prevailed, and in some way, they would have had to have some transparency, it wouldn't have been enough?

I think that's right. I think you need to go through periods like this for people to really understand the risks. And again, I come back to my bank regulators. You have institutions that were enormously leveraged and taking very, very highly speculative positions, yet under the nose of scores of regulators. It was, a, I think a function of the complexity of a lot of the things that were happening, but b, a function of the sort of attitude towards regulatees -- that they know that they're in control, they know best, and that we're going to step back and let them do their thing.