Bill Clinton And Derivatives

Bill Clinton, whose Administration set the ball rolling on a lot of the structures that ultimately led to ruin in the financial markets, gives a pretty honest take of where he feels he went right and wrong:

Mr. CLINTON: Now, there basically have been three charges, if you will, laid at our doorstep, because everybody recognizes that I vetoed the securities reform bill and that we had a very different economic philosophy. But they — the three charges are one, because I enforced the Community Reinvestment Act for the first time and over 90 percent of all lending done under that law was done when I was president, $300 billion, that part of that was a lot of little banks made loans to people they had no business making loans to to buy houses so they could check the box for the Community Reinvestment Act. That’s the right-wing argument.

Then there’s the argument from the left that I shouldn’t have signed the bill that got rid of the Glass-Steagall law because that enabled banks and investment banks in effect to merge their functions.

And then there’s the argument that I make, which is that I should have raised more hell about derivatives being unregulated. I believe the last one is by far the most valid, although I don’t think that the Congress would have permitted anything to be done because Alan Greenspan was against it [...]

But I do believe on the derivatives they made the argument, the people who were against regulating it, that people like you weren’t buying derivatives. It wasn’t like you were investing your 401(k) in derivatives. You were investing your 401(k) in mutual funds, which were subject at least under normal times to the jurisdiction of the S.E.C., which was supposed to be minding the store. And so because we had a hostile Republican Congress which threatened not to fund — I don’t know if you remember this but we had a huge knock-down fight when they threatened not to fund the S.E.C. because of what Arthur Levitt was doing to try to protect the American economy from meltdowns. They said, “Oh, he’s interfering with a free market” and all that. This is what he’s supposed to do.

They argued that nobody’s going to buy these derivatives, we’ll do it without transparency, they’ll get the information they need. And it turned out to be just wrong; it just wasn’t true. And once you got that massive amount of money invested in derivatives that people thought — it’s like these credit default swaps, where people thought, the Lehman people talk about it, they thought, or the A.I.G. people, they thought it was 100 percent safe investment, they thought there would never be defaults on these mortgage securities. So of course you wanted insurance there because you got the insurance premium, you make the profit and you couldn’t possibly lose money, right? Well, it turned out to be all wrong. That rested on a lot of assumptions, including the fact that the ratings agencies would do a good job, which didn’t happen, in evaluating risk. So I very much wish now that I had demanded that we put derivatives under the jurisdiction of the Securities and Exchange Commission and that transparency rules had been observed and that we had done that. That I think is a legitimate criticism of what we didn’t do.

Clinton doesn't buy the arguments about Glass-Steagall or the Community Reinvestment Act. And much of his argument rests on the fact that the Bush Administration just gutted the regulatory apparatus, particularly the SEC, and so he was operating under a different environment. And David Leonhardt makes another very good point - the Clinton Administration allowed the run-up of the dot-com stock bubble, so thinking they would have charged in and stopped the housing bubble doesn't really hold water. They were lucky to get out of office when they did.

But this is pretty honest, and points to Clinton's instincts on this, which were always more finely attuned than his advisors. The derivatives market took off after Clinton left office, when the stock bubble popped and the relationship between housing and mortgage-backed securities started to realize itself. At the same time, Long-Term Capital Management, which invested heavily in derivatives, failed during Clinton's tenure (he couldn't come up with the name in the interview), and apparently this led Clinton to approach Alan Greenspan on the subject, who predictably said that derivatives were a niche market. In other words, Clinton deferred to Greenspan. So how would he have stopped the bubble from inflating, then? I can't see Clinton having bungled the issue as much as Bush, but while his instincts were solid, the follow-through, not so much.

Meanwhile, we have the benefit of hindsight now, and certainly a desire to regulate derivatives. Which makes the banksters unhappy:

For credit-default swaps, information about intraday trades and prices has long been controlled by a handful of large banks that handle most trades and earn bigger profits from every transaction they facilitate if prices aren't easily accessible.

For example, credit-default swaps tied to bonds of companies such as General Electric Capital and Goldman Sachs typically have a pricing gap of 0.1 percentage point between the bid and offer price. That translates into a $40,000 margin for every $10 million in debt insured for five years. Greater price transparency could narrow that gap, lowering costs for buyers and sellers but reducing fees for banks.

Just so you know who's looking out for you. Now, if the banksters still run the place, as Dick Durbin said, then everyone can be right about the dangers of the financial markets and it wouldn't amoung to a hill of beans.

Brooksley Born And The Financial-Political Complex

I almost missed this one yesterday, but the WaPo had a profile of Brooksley Born, the lawyer who, while the Clinton Administration's Chairman of the Commodity Futures Trading Commission, foresaw the coming crisis in unregulated derivatives, including credit default swaps, and staged an ultimately futile campaign to rein them in. Within this article are some of the most fascinating and unbelievable quotes from the men who led our financial efforts then - and some who continue to do so now.

You expect a house organ like the Wall Street Journal to respond to Born's concern over derivatives by saying, "the nation's top financial regulators wish Brooksley Born would just shut up." But this line just absolutely floored me:

Born's baptism as a new agency head in 1996 came in the form of an invitation. Federal Reserve Chairman Alan Greenspan -- routinely hailed as a "genius," the "maestro," the "Oracle" -- wanted her to come over for lunch.

Greenspan had an unusual take on market fraud, Born recounted: "He explained there wasn't a need for a law against fraud because if a floor broker was committing fraud, the customer would figure it out and stop doing business with him."

This is the Randian mindset of the perfection of the market that has caused so much pain for so many millions of people. Greenspan either was literally so in thrall to the Masters of the Universe and his perfect little system that he found greed written out of the program, or so clever that he used transparently idiotic theories to simply allow legalized theft. Either way, everyone should know that this is the philosophy under which the United States, and really the world, financial system operated for three decades, directly from the mouth of its most powerful practitioner. Andrea Mitchell should resign in shame.

Sadly, however, it doesn't stop there.

That was just the beginning. By early 1998, Born had also tangled with Treasury Secretary Robert Rubin, his deputy, Summers, and Securities and Exchange Commission head Arthur Levitt, not to mention members of Congress, financial industry heavyweights and business columnists. She wanted to release a "concept paper" -- essentially a set of questions -- that explored whether there should be regulation of over-the-counter derivatives. (Derivatives are so-named because they derive their value from something else, such as currency or bond rates.)

They warned that if she did so, the market would implode and predicted tidal waves of lawsuits. On top of that, Rubin told her, she didn't have legal authority to regulate the derivatives anyway [...]

In early 1998, Born's plan to release her concept paper was turning into a showdown. Financial industry executives howled, streaming into her office to try to talk her out of it. Summers, then the deputy Treasury secretary, mounted a campaign against it, CFTC officials recalled.

"Larry Summers expressed himself several times, very strongly, that this was something we should back down from," Waldman recalled.

In one call, Summers said, "I have 13 bankers in my office and they say if you go forward with this you will cause the worst financial crisis since World War II," recounted Greenberger, a University of Maryland law school professor who was Born's director of the Division of Trading and Markets. Summers declined to comment for this article.

The discordant notes crescendoed in April 1998 during a tension-filled meeting of the President's Working Group, a gathering of top financial regulators that periodically met behind closed doors at the Treasury Department. At that meeting, Greenspan and Rubin forcefully opposed Born's plans, Waldman said.

"Greenspan was saying we shouldn't do it," Waldman recalled. "Rubin was saying we couldn't do it."

The rest of it reads like a Hollywood potboiler, with Born trying to outmaneuver her more powerful counterparts, ultimately falling short even after being partially vindicated by the failure of Long Term Capital Management, and finally resigning. We're living with the consequences.

But surely you recognize some of the Democratic named involved in shutting Born down. Now let that color your impressions of this report (subs. req.):

Some banks are prodding the government to let them use public money to help buy troubled assets from the banks themselves.

Banking trade groups are lobbying the Federal Deposit Insurance Corp. for permission to bid on the same assets that the banks would put up for sale as part of the government's Public Private Investment Program.

The lobbying push is aimed at the Legacy Loans Program, which will use about half of the government's overall PPIP infusion to facilitate the sale of whole loans such as residential and commercial mortgages [...]

Some critics see the proposal as an example of banks trying to profit through financial engineering at taxpayer expense, because the government would subsidize the asset purchases.

Surely, Larry Summers would follow the refrain of the Maestro, that there couldn't possibly be any fraud because the customer would figure it out and stop doing the business. Of course, in this case, the "customer" and the vendor are... the same people.

James Kwak has more on this plan, which I pretty much expected (what's to stop the banks from using shell companies to buy up their own assets at the right price, with government guarantees, even if the Feds break precedent and reject this?). Kwak has a good short version of this: "It allows a bank to sell half of its toxic loans to Treasury – at a price set by the bank."

And he wants Tim Geithner and Sheila Bair to reject this. But the experience of Brooksley Born suggests that the problem with the incestuous political-financial complex is one of mindset. They view the goals of the banksters as superior to the goals of the country, or at best relatively aligned. And thus, regulating those complex financial instruments, or blocking clear giveaways of public money, somehow equals hurting the greater economy. Whether through dime-store philosophy or simply looking out for the interests of the wealthy - and themselves - we've become completely subservient to oligarchs who clearly value their success over that of the country. Which is fine for them - but there's nobody advocating for the greater public, warning of the dangers of runaway capitalism, arguing for a return to the core mission of finance, to smoothly flow capital to those who need it, rather than the Wild West show we still see today. In other words, there are no more Brooksley Borns. And even if there were, the system is so rotted that not even someone of her talent and determination can get the message through. Despite the worst financial crisis since the Depression.

But never mind, because we have "green shoots."

Here's the coda to the Born article, by the way:

Born keeps informed, but she has other concerns, bird-watching jaunts and trips to Antarctica to plan, mystery novels to read, four grandchildren to dote on. "I'm very happily retired," she says. "I've really enjoyed getting older. You don't have ambition. You know who you are."

The Whine Of The Brooks Brothers Suits

Hedge fund managers are awfully steamed about the Snidely Whiplash mustache that Obama hung on them yesterday:

President Obama's harsh attack on hedge funds he blamed for forcing Chrysler into bankruptcy yesterday sparked cries of protest from the secretive financial firms that hold about $1 billion of the automaker's debt.

Hedge funds and investment managers were irate at Obama's description of them as "speculators" who were "refusing to sacrifice like everyone else" and who wanted "to hold out for the prospect of an unjustified taxpayer-funded bailout."

"Some of the characterizations that were used today to refer to us as speculators or to say we're looking for a bailout is really unfair," said one executive who spoke on condition of anonymity because of the sensitivity of the matter. "What we're looking for is a reasonable payout on the value of the debt . . . more in line with what unions and Fiat were getting." [...]

"It sounds like people are being bullied right now," said Ron Geffner, a partner at the law firm Sadis and Goldberg, which represents hedge funds. "To play the 'I stand with Chrysler, I stand with families, I stand with the dealers, I stand with the consumers' -- that's great conceptually, but . . . I stand with the fact that we live in a capitalist society where companies who don't modify their business plans and stay current die and go by the wayside."

It's simply a lie to say they wanted a payout in line with the unions and Fiat. They wanted a bankruptcy so they could cash in on credit default swaps that pay out in the event of a bankruptcy, and make a killing at the expense of Chrysler.

Also, if we indeed do live in a capitalist society, where everyone is treated equally and companies must act within the boundaries of the regulatory landscape, then I expect these hedge fund managers to march en masse to Capitol Hill and demand they be charged the regular marginal tax rate on their income rather than the capital gains rate that allows them to hide billions from the federal government. Surely, because they believe in capitalism and the level playing field so much, they'll get right on that.

I don't have a problem with investors acting purely in their economic interests, but government has a role to play in making sure those interests aren't as perverse as this, where a minority of investors (the bigger banks signed off on the 28 cents-on-the-dollar deal) can throw a company into bankruptcy because of the side bets. And those investors can own up to the fact that their desire for CDS money left them rooting for bankruptcy. It'd be the honest thing to do.

The Bondholder's Gamble

President Obama characterized the withholding of funds to GM as a chance to give them 60 days to submit plans for further restructuring, but clearly he has already decided that he would rather try an accelerated bankruptcy to force haircuts on all the key stakeholders. It looks like that will take the form of a good GM and a bad GM.

The Obama administration's auto task force has pressed General Motors to consider a form of bankruptcy that would split the company in two, with one entity containing the unprofitable units and the other in essence becoming the new GM consisting of the company's more successful brands, people familiar with the matter say.

The company prefers not to ever enter bankruptcy because the mere word would stir fear among consumers and further damage sales. But GM will be forced to do so if it fails to win concessions from its bondholders, union and dealers within 60 days. Then bankruptcy court would compel GM stakeholders to make sacrifices, rehabilitating the company by clearing away billions of dollars of debts from its balance sheet.

"They're all options. They're all being studied," Kent Kresa, GM's new chairman, said in an interview. "The preferred [option] is to do it outside of bankruptcy."

You would think this would be the last outcome sought by the bondholders, as their stakes would be crammed down in a bankruptcy court. However, I wondered earlier whether they think they have a better shot from a judge than from a negotiation. And Autoblog reports on another potential reason - they could cash in their credit default swaps.

The bondholders appear to be the biggest obstacle to restructuring. They're not allowing GM to reach its government-mandated target for debt reduction because they would lose much of their investment in the process. According to Denninger, however, the biggest and most savvy of those bondholders could get 100% of their investment back if GM files for bankruptcy. Those bondholders would have had their bonds backed by credit default swaps (CDS), which Denninger supposes would have been written in large part by insurance giant AIG. If that's the case, then we the taxpayers are on the hook to repay 100% of those bonds because the government has agreed to fulfill AIG's CDS collateral obligations.

Thus, these particular bondholders would have no reason to help GM stay afloat by reducing its debt obligations. If GM goes under, they would just wait for checks from the government to be made whole again. Denninger goes on to say that in such a scenario, these bondholders could make even more than 100% of their investment back because the government backing takes place "even if the bonds have a recovery in bankruptcy." The only way to stop this would be for the government to decline to back any more AIG obligations, which could then bankrupt the "too big to fail" AIG depending on its ultimate exposure, but would save GM. Decisions, decisions...

Wow. Just, wow.

I Keep Forgetting To Regulate*

As much debate and consternation as there has been over the Geithner plan for toxic assets, we are seeing today a move forward on overhauling financial rules, which to my not-economist ears sounds fairly good. In particular, regulating hedge funds and CDS traders makes a ton of sense.

WASHINGTON — The Obama administration will detail on Thursday a wide-ranging plan to overhaul financial regulation by subjecting hedge funds and traders of exotic financial instruments, now among the biggest and most freewheeling players on Wall Street, to potentially strict new government supervision, officials said.

The plan, which would require Congressional approval, would give the government vast new powers over “systemically important” banks and other financial institutions that are so big that their collapse would jeopardize the economy as a whole.

The government would have the power to peer into the inner workings of companies that currently escape most federal supervision — insurance companies like the American International Group, multibillion-dollar hedge funds like the Citadel Group and private equity firms like the Carlyle Group or Kohlberg, Kravis & Roberts.

If regulators decided that a company had become “too big to fail,” as was the case with A.I.G. in September, they would subject it to much stricter capital requirements than smaller rivals and much closer scrutiny of its borrowing levels and its trading partners, or counterparties.

But the most striking new proposals, and the ones that may provoke the most heated opposition from the industry, would regulate so-called private pools of capital — hedge funds, private equity funds and venture capital funds — and the gigantic market in financial derivatives, including instruments like credit-default swaps, the insurancelike instruments that allow investors to hedge against bond defaults.

Hedge funds and private equity funds manage money for wealthy individuals and institutions like pension funds. They operate almost entirely outside the regulation of either the Securities and Exchange Commission or the Federal Reserve.

Under the administration proposal, hedge fund, private equity and venture capital fund advisers would for the first time have to register with the S.E.C. They would be required to provide the government — on a confidential basis — information on how much they borrow to leverage their investments as well as information about their investors and trading partners.

The S.E.C. would then share those reports with a new “systemic risk regulator.” At least for the moment, Mr. Geithner is ducking the crucial question of who the powerful risk regulator should be, a contentious issue among Democratic lawmakers.

A plan, of course, is one thing - getting it through Congress is quite another. And there's a compelling strain of thought that the laws on the books today could have stopped much of this crisis, and what we actually lack is regulatory will. Perhaps taking this completely out of the realm of politics AND Wall Street - I've no idea how, maybe hiring the Blue Moon Detective Agency - would help, but essentially the regulators have to WANT to regulate to protect the public. And yet, we have the elites we have:

Joe Donnelly asked Tim Geithner whether we ought to eliminate naked default swaps. Geithner said that it's too hard to distinguish hedges from gambling. Donnelly pointed out that we're taking money out of truck drivers' pockets and waitress' pockets to pay off Wall Street's gambling debts. Ultimately, though, Geithner said we don't need to--and that it would be very hard to--do that.

I guess the truck drivers will still be asked to pay off rich men's gambling debts.

Maybe Lord Stern's idea for an independent international body with an endowment and no possibility of recall makes the most sense. Because I don't have a lot of trust in anything resembling independence on this side of the pond.

* - Anyone who knows the provenance of the headline gets a cookie.

Condition Critical

The AIG bonus scandal is a real crisis for this Administration. Now revealed to be as big as $450 million dollars, the money is weighted heavily toward the Financial Products division that wrote all the credit default swaps which contributed to nearly taking down the global financial system, and there are only 370 people at this division, so you're looking at about $1M per person for the unit that lost $40 billion and destroyed their own company. At this point, I'm not sure why AIG NEEDS a Financial Products division at all. Far from shoveling them $450 million dollars, they shouldn't have a job. Yet that's what CEO Edward Liddy is doing, and pretty brazenly - saying that he's very sorry, but his people are getting their cash. I agree with Hilzoy:

And extortion is what it is (morally; I am not a lawyer, and I'm not trying to make a legal claim.) If I ran someone down in a car on a deserted road, it would take a lot of gall for me to ask him to pay me an exorbitant price to take him to the hospital since there's no other car around. When you run someone down, taking him to the hospital is the least you can do, and payment shouldn't so much as enter the picture.

Likewise, when you run the world financial system and the American taxpayer down, it takes a lot of gall to ask for not just a performance bonus, but a retention bonus as well. Any remotely decent person would stay and try to unwind the damage s/he had caused, if s/he was the only person who could do so, and would be content with his or her salary. (After all, it's not as though people in financial services are generally underpaid.)

The expressions of outrage on the part of the axis of Geithner and Summers are nice, but the shrug of the shoulders and words like "There's nothing we can do" are disingenuous at best. First of all, we the people own AIG. We have an 80% stake, and shareholders of that magnitude ought to be able to dictate at least some terms. Second, this "contractual obligation" argument was not operative when auto workers - whose companies are not owned by the government at an 80% rate - were forced to tear up their own contractual requirements on wages and accept new terms as a condition for their industry bailout.

Jane has a long piece on this today.

The White House is worried about backlash over AIG's payout of $450 million in bonuses to the executives in its high flying Financial Services Group, the out-of-control derivatives trading arm that looted the company, destroyed its stock and contracted for huge bonuses even after they saw the risk of collapse.

Robert Reich says that the administration's failure to stop this is a sign that "our democracy is seriously broken," and it is. When the story was initially leaked by a "senior government official," this was the excuse for the administration's impotence in what can only be characterized as a grand theft [...]

American taxpayers now own 80% of AIG. They'll be paying back the government, and paying off the bonuses, with our money. There is no reason to be tiptoeing around these people.

Are Geithner and Summers are just too aligned with Wall Street interests to do what needs to be done?

The bottom line is -- nobody trusts them. Congress needs to use its subpoena power to get a hold of these AIG contracts and make their own analysis.

President Obama is in a tough spot. Today he said that he intends to stop the bonuses from going forward, putting him in direct contrast to his own economic advisers.

"It's hard to understand how derivative traders at AIG warranted any bonuses, much less $165 million in extra pay," Obama said at the outset of an appearance to announce help for small businesses hurt by the deep recession.

"How do they justify this outrage to the taxpayers who are keeping the company afloat," the president said.

Obama spoke out in the wake of reports that surfaced over the weekend saying that financially strapped American International Group Inc. was paying substantial bonuses to executives.

Noting that AIG has "received substantial sums" of federal aid from the federal government, Obama said he has asked Treasury Secretary Timothy Geithner "to use that leverage and pursue every legal avenue to block these bonuses and make the American taxpayers whole."

He's saying the right things. But if the functionaries continue to look at what's best for Wall Street over what's best for the people, Obama will be caught. The fact that AIG is vowing to cut bonuses in the future will be of little consequence. If the 2008 bonuses stand, there will be hell to pay, and eventually Republicans will figure out how to play this game.

This is arguably made worse by the fact that AIG has now released the list of beneficiaries to its rescue, the counterparties who were paid off in the process of the bailout. It's pretty much the same group of domestic and foreign banks expected, but now the bonus babies at AIG are being paid to funnel money to Goldman Sachs and the like. The optics are terrible. And if the Administration is not careful, and continues to please elites at the expense of the people, they will face a massive backlash.

...Marcy Wheeler thinks AIG is making a veiled threat to the government, that either they get their bonuses or they would trigger a default event and take the taxpayer for billions more. Honestly, how is this any different from what they are already doing? If we cancelled the contracts and let France appoint a designee, wouldn't we be done with this company? I'm sure it's more complex than that, but I'd be fine with a lawsuit and a final payoff to end it... I understand that this would set off an event that could pull the whole house down, so obviously it's quite a serious terrorist act AIG managed to pull.