Keeping Outsized Banker Pay Safe

“Why did nobody see it coming?”

Queen Elizabeth II, to economics professor Luis Garicano, November, 2008.

It’s not quite true, as Her Majesty assumed, that nobody saw it coming. There were several who raised concerns. One of these was Brooksley Born, the head of a small commission with the mind-numbing name of the Commodity Futures Trading Commission (CFTC).

In1998, Born, rightly dubbed, “The Cassandra of the Crisis”, became alarmed at what was possible after the Clinton great bank deregulation:

* commercial banks were once again allowed to speculate in securities

* there was a new unregulated derivative market

Anything unregulated in the financial system is called ‘shadow’.

* At that time, regulated banks were dealing with shadow banks (hedge funds);

* In the shadow derivatives market of CDOs and CDSs; and

* With investments containing a substantial number of mortgages issued by shadow banks (private lenders).

The opportunity for fraud was limitless!

The dark derivative market was compared to a highway without dividing lines, speed limits-or cops. Born argued there should be police.

Born circulated a concept paper calling attention to this dark market with so much potential for fraud. The retaliation by economic advisors to the president was swift, complete, and effective. They included the most influential economists and regulators of the day:

* Alan Greenspan, then head of the Federal Reserve Bank;

* Larry Summers, assistant Treasury Secretary, and former Harvard president;

* Treasury Secretary Robert Rubin, an ex-Goldman Sachs CEO; and

* Arhtur Levitt, Chairman of the Securities and Exchange Commission.

These economists, and all economists who influenced the government and the media, were united in the neoliberal belief best expressed by Reagan as, “government is the problem”. They believed the market would regulate itself. And so, they sprang to action to stop that nosy regulator from investigating the CDO/CDS situation.

They pressured Congress to quickly shut her up and shut her down. Here is Born’s description on Frontline in 2010 of what Congress did:

“And as a result of that report, a statute was passed in 2000 called the Commodity Futures Modernization Act [CFMA] that took away all jurisdiction over over-the-counter derivatives from the CFTC. It also took away any potential jurisdiction on the part of the SEC, and in fact, forbids state regulators from interfering with the over-the-counter derivatives markets. In other words, it exempted it [the derivative market] from all government oversight, all oversight on behalf of the public interest. And that’s been the situation since 2000.” [My emphasis]

Bankers made their supersized paychecks by investing in these markets.

Because banker paychecks could be affected, the Act went further. States could possibly step in and regulate the CDS as insurance (which it was) or as gambling (which it often was as the purchaser usually did not have a financial interest in the underlying asset). So the Act prohibited state legislatures requiring a financial interest and a reserve fund to meet claims.

The Market Would Regulate Itself

Born remembers this chat with Alan Greenspan.

“Well, Brooksley, I guess you and I will never agree about fraud,” Born remembers Greenspan saying.

“What is there not to agree on?” Born says she replied.

“Well, you probably will always believe there should be laws against fraud, and I don’t think there is any need for a law against fraud,” she recalls. Greenspan, Born says, believed the market would take care of itself.

Greenspan says he does not remember this conversation.

Born stands by her version.

Frank Partnoy, a former Wall Street investment banker who is now a professor at the University of San Diego law school told Rick Schmitt of Stanford Magazine:

“History already has shown that Greenspan was wrong about virtually everything, and Brooksley was right”.

After the Fall

The economists who were united in wrongly pressuring the government to prevent Born from looking into the shadow derivative market-and other economists of the same school-were kept in place to devise the solution to the 2008 near financial meltdown.

The Reforms After 2008

After 2008, Congress realized that the financial markets could not regulate themselves; there had to be regulations. However, they did not return to the proven effective solution of the clear and understandable s16 of Glass-Steagall.

The Obama administration asked former Treasury Secretary Paul Volker to draft a set of regulations to control the risk to deposit money by excessive investment in the derivative markets. Volker submitted an eight-page document eventually called the Volcker Rule. There was a poor choice in the wording in his proposal: It applied to ‘holding banks’, not commercial banks.

The term ‘holding banks’ includes both investment and commercial banks. So, the investment bank lobby could attack the regulations with arguments of some merit. Soon the Volcker Rule was gutted to the point that it is completely ineffective against both investment and commercial banks.

Tyler Gellasch is no ordinary financial-reform advocate: He co-wrote the draft Volcker Rule, while serving as senior staff to then-Senator Levin. He said on Twitter that the Volcker Rule has been rendered completely ineffective by amendments.

“ After tens of millions of dollars and a decade of lobbying, the Volcker Rule is a shadow of the original idea and simply no longer works for anyone-it certainly cannot protect the public from another disaster.”

Alan Blinder, a former Vice Chairman of the Federal Reserve, summarized the banking regulation situation in the headline of his article on the Wall Street Journal in 2013: Alan Blinder: Five Years Later, Financial Lessons Not Learned. Blinder warned,

“ Far from being tamed, the financial beast has gotten its mojo back-and is winning. The people have forgotten-and are losing.”

In an article on Think Advisor, Janet Tavakoli put it more colourfully:

“Given that we haven’t driven speculators out of the market, it’s a good idea to ban credit default swaps altogether. And now we’ve made it worse. It’s like handing a drunk driver who got into a crash the keys to a bigger, faster car together with a bottle of vodka”.

Acknowledgement: Money image by PublicDomainPictures on pixabay

Originally published at https://jandweir.substack.com.