A modified excerpt from Dan Riker’s still-in-process book, “Let’s Do What Works and Call it Capitalism.”
The latest rumors out of Washington have Lawrence Summers in the lead to be President Obama’s choice as the successor to Ben Bernancke as Chairman of the Federal Reserve. Next to appointments to the Supreme Court, arguably the most significant appointment power of the Presidency is the selection of the Fed Chairman.
Through its control of the nation’s money supply and interest rates, the Fed controls the nation’s monetary policy, which, because the dollar is the reserve currency for most other countries, also has an enormous impact on the global economy. And even though the President appoints the Fed Chairman and the Senate has to confirm the appointment, the Fed Chairman operates autonomously. There is no Presidential or Congressional review of the decisions of the Fed. The Chairman of the Fed may have the greatest power over the nation’s economy of any single public official, including the President.
Thus, any appointment to this position undergoes considerable scrutiny. In the case of Lawrence Summers, one of the nation’s most distinguished economists, there is a long, and sometimes controversial, record to be scrutinized. That he was portrayed as a character in the movie, “The Social Network,” when he was the President of Harvard University, probably gave him more public attention than anything else he has done. But he has done much more, and, in light of the enormous power he soon may wield, what he did should be reviewed carefully.
When Bill Clinton still was President, Brooksley Born, then chair of the Commodities Futures Trading Commission, attempted to get Congressional approval to regulate the then rapidly growing derivatives market. Her effort failed because of the opposition of Fed Chairman Alan Greenspan, Treasury Secretary Robert Rubin, and Lawrence Summers, who then was Deputy Treasury Secretary, but who would succeed Rubin in 1999. Many think that opposition was responsible in part for the derivatives debacle that ensued in 2007-8.
The July, 1998, Summers’ testimony of before the Senate Agriculture Committee, which had jurisdiction over commodities and commodities regulation, is very revealing of prevailing thought of the business and financial community in the late 1990s. It basically was no different from that of those who, at the turn of the 20th Century, President Theodore Roosevelt described as “malefactors of great wealth.” The only good regulation was no regulation.
He said to the committee:
The OTC derivatives market is a vast, increasingly global industry. By some estimates, the market now has a notional value of around $26 trillion, with contracts of more than $4 trillion undertaken in 1997 alone. The dramatic growth of the market in recent years is testament not merely to the dynamism of modern financial markets, but to the benefits that derivatives provide for American businesses.
By helping participants manage their risk exposures better and lower their financing costs, derivatives facilitate domestic and international commerce and support a more efficient allocation of capital across the economy. They can also improve the functioning of financial markets themselves by potentially raising liquidity and narrowing the bid-asked spreads in the underlying cash markets. Thus, OTC derivatives directly and indirectly support higher investment and growth in living standards in the United States and around the world.
Any disruption to this market brings two large potential costs. First, it could inhibit the use of an important risk management tool, thus reducing the efficiency of our financial markets in channeling capital to its most effective use.
Second, uncertainties of this kind threaten the position of the United States relative to other global trading centers, thereby depriving our economy of the multiple benefits which this activity affords. [1]
Summers went on to tell the committee that the derivative market did not have the characteristics normally requiring regulation:
• First, the parties to these kinds of contract are largely sophisticated financial institutions that would appear to be eminently capable of protecting themselves from fraud and counterparty insolvencies and most of which are already subject to basic safety and soundness regulation under existing banking and securities laws;
• Second, given the nature of the underlying assets involved – namely supplies of financial exchange and other financial instruments – there would seem to be little scope for market manipulation of the kind seen in traditional agricultural commodities, the supply of which is inherently limited and changeable.
To date there has been no clear evidence of a need for additional regulation of the institutional OTC derivatives market, and we would submit that proponents of such regulation must bear the burden of demonstrating that need.[2]
Stripping this testimony to its essence, Summers was telling Congress that a great number of important people, many of whom were friends of both Summers and the Senators, were making huge amounts of money in the rapidly growing derivatives market, and would be very unforgiving if Congress allowed any regulation. He cited, as a positive, the size of the derivatives market, which at that time was more than twice the GDP of the United States, and then blandly said the institutions involved were “imminently capable of protecting themselves…”
They were not, of course, and partly because he was wrong about the protection of the existing banking and securities law regulations. In 1999, Summers was instrumental in the repeal of portions of the Glass-Steagall Act, which had restricted combinations of investment and commercial banks.
He also was wrong about the potential for manipulation. The bursting of the housing bubble ion 2006 that was caused by manipulation of the mortgage market brought a flood of ruin from which no combination of the institutions involved could protect themselves.
The truth is there were no protections against the avarice and greed that gripped the unregulated derivative markets, and led to the creation of trillions of dollars of unbelievably unstable financial instruments. It took a massive government bailout to prevent a collapse of the entire banking system, which would have caused an economic disaster without historical precedent.
And even worse, there still are no adequate protections against something similar happening again.
A 1997 book, F.I.A.S.C.O., by a Morgan Stanley trader, Frank Partnoy, detailed the risks of the derivatives market.[3] The Afterword to the 2009 edition of the book provides both a comprehensive and easy to understand description of the entire subprime mortgage derivative scandal that nearly brought down the entire banking system in 2008. Many people were aware of the pending disaster. Partnoy wrote in his Afterword that some hedge fund managers shorted subprime-linked derivatives before the housing market collapsed and made billions of dollars. This knowledge somehow eluded the Bush Administration, or was ignored.
The Wall Street demand for subprime mortgages to use in highly profitable packages and derivatives was so great that it caused mortgage lenders to dramatically reduce credit requirements, interest rates and down payments to generate more home loans. The easy mortgage money pushed housing values way above all-time highs in 2006.[4] When the bubble burst, all homeowners, not just those with subprime mortgages, lost nearly a third of the value of their homes, on average, wiping out trillions of dollars of equity. That left millions of homeowners “under water,” with mortgages higher than the value of their homes. The very slow recovery of home values in much of the country, coupled with foreclosures, continues to depress economic growth.
With the barrier between investment banks and commercial banks no longer in existence because of the partial repeal of the Glass-Steagall Act, the collapse of the subprime mortgage derivative market nearly brought down the entire banking system. Subsequent investigations revealed that in the process of creating the subprime investment packages, many banks lost the documentation of the underlying mortgages, which made foreclosures illegal. In an effort to cover this up, some banks forged mortgage documents.[5] However, to this time, no major banking executives have faced prosecution.
The derivatives market continues without significant regulation. There still are no barriers between commercial and investment banks. The mergers that resulted from the bank crisis have actually made concentration in the finance industry greater, and increased the banking system’s vulnerability. The major banks have fought regulation, and have done everything they can to water down, or delay, the provisions of the Dodd-Frank Act that was designed to restore some regulation.
The nation’s financial system remains extremely vulnerable. The federal agency that controls the monetary policy of the nation, and which also has a huge impact on banking systems around the world, soon may be headed by a man who was highly instrumental in removing regulations that had prevented a major banking crisis for about 70 years. Within seven years of the repeal of these safeguards, the unregulated excesses of the banks nearly led to a complete collapse of our financial system, the impact of which probably is beyond our imagination, but it almost certainly would have caused another Depression if the bank bailouts had not occurred.
Notes
[1] Treasury Deputy Secretary Lawrence H. Summers testimony before the senate committee on agriculture, nutrition, and forestry on the cftc concept release: https://www.treasury.gov/press-center/press-releases/Pages/rr2616.aspx
[2] Ibid.
[3] Partnoy, Frank. F.I.A.S.C.O. New York: Norton, 1997. Reissued in 2009 with a new Afterword.
[4] https://www.ritholtz.com/blog/2011/04/case-shiller-100-year-chart-2011-update/
[5] For a particularly riveting account of the misbehavior of one bank, Bank of America, see Taibbi, Matt. “Too Crooked to Fail.” Rolling Stone. March 29. 2012.
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