In the 1990′s, Brooksley Born, who chaired the Commodity Futures Trading Commission at the time, tried to warn federal bank regulators, including Federal Reserve Chairman Alan Greenspan, about the dangers of over-the-counter derivatives. To put it mildly, her alarm-sounding did not go over well:
Born’s proposal stirred an almost visceral response from other regulators in the Clinton administration, as well as members of Congress and lobbyists. The economy was sailing along, and the growth of derivatives was considered a sign of American innovation and a symbol of the virtues of deregulation. The instruments were also a growing cash cow for the Wall Street firms that peddled them to eager takers. Ultimately, Greenspan and the other regulators foiled Born’s efforts, and Congress took the extraordinary step of enacting legislation that prohibited her agency from taking any action.
Of course, as we now know, the huge, opaque derivatives market helped to unleash a financial cataclysm, particularly by imploding the insurance giant AIG. “No federal or state public official had any idea what was going on in those markets, so enormous leverage was permitted, enormous borrowing,” Born said. “There was also little or no capital being put up as collateral for the transactions.”
Since Born saw the problems with the derivatives market where so many others didn’t, it’s significant that she has lent her support to the financial regulatory reform package that passed the House this week and is due for a vote in the Senate when the July 4th recess ends. “[The bill] is an important step forward in regulating the over-the counter derivatives market and I very much hope it is enacted into law,” Born said.
Despite the unfortunate watering down of the provision forcing banks to spin their derivatives trading desks into separately capitalized entities, the derivatives title of the Dodd-Frank financial reform bill is quite strong. It places standardized derivatives trades onto public exchanges (like the stock exchange) and forces customized trades to be cleared by clearinghouses (avoiding an AIG-type situation where one party to a trade has insufficient capital on hand to back it up). This is getting lost in the drama surrounding Sen. Scott Brown’s (R-MA) hemming and hawing over the bill, but it’s an important set of reforms that needs to become law.