Wall Street Wants Congress To Roll Back Financial Derivatives Regulations
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Revisiting the lessons from deregulating derivatives is particularly important right now because Congress seems to have forgotten them. A report we just issued provides a road map of how derivatives wrecked the economy in 2008 and could do so again if Wall Street gets its way.
Nine bills that would roll back the derivatives reforms created in the wake of the financial crisis are moving in Congress. These proposals, most of which have already passed in committee, have been put forth in the name of furthering the competitiveness of U.S. companies and creating jobs for Main Street. These are quite brazen claims, since deregulating derivatives arguably did more to harm economic competitiveness and job creation than anything Congress has done for a very long time.
Here is the history, in brief: At the end of the Clinton administration, financial derivatives were relatively new and sat in a regulatory netherworld. In practice, they were not regulated. But they bore all the hallmarks of traditional futures, which by law must be traded on regulated exchanges.
Federal Reserve Chairman Alan Greenspan and successive Treasury Secretaries Robert Rubin and Lawrence Summers (a trio Time magazine dubbed The Committee to Save the World ) argued that financial derivatives investors were too “sophisticated” to require oversight. Regulating derivatives would “cause the worst financial crisis since World War II,” Summers claimed.
In 2000, with the passage of the Commodity Futures Modernization Act, Congress established a regulation-free haven for financial derivatives. Derivatives soon became a petri dish for the growth of financial risk-taking, especially relating to the housing market.
In rough terms, derivatives dealers sold hundreds of billions of dollars worth of quasi-insurance policies (called credit default swaps) on mortgage-backed securities to holders of the securities. The illusion of protection provided by these insurance policies helped create a voracious appetite on Wall Street for mortgages to bundle into securities. This, in turn, led mortgage originators to adopt laughably low underwriting standards, causing housing prices to soar to unsustainable levels.
When reality intervened and mortgages defaults began occurring in droves, holders of defaulted mortgage-backed securities submitted claims to the providers of their credit default swap “insurance policies” (primarily American International Group, or AIG), only to learn that AIG could not make good on its promises. The absence of supervision of derivatives had permitted AIG to amass risks well in excess of its resources—and thereby put the entire economy in grave jeopardy.
AIG’s inability to pay its counterparties threatened to cause a ripple effect of institutional failures that could have thrown the economy back into the Stone Age. A $700 billion taxpayer-funded bailout was ordered up to prevent a total collapse of the financial system. Regular Americans were left to suffer through the deepest recession since the Great Depression.
Experts agree with the essence of the summary above. Each of the members of The Committee to Save the World, for instance, has recanted his advocacy for a laissez-faire approach to derivatives. Rubin now says he even favored regulation when critical decisions were being made in the late 1990s, but that “ very strongly held views in the financial services industry in opposition to regulation were insurmountable .”
Which brings us to the present: The Dodd-Frank Wall Street Reform and Consumer Protection Act instituted a series of commonsense reforms, including requirements for derivatives trades to occur on designated exchanges. This key provision would ensure that prices are transparent and that a centralized clearing agency guarantees the credit worthiness of trading participants. This is how stocks and futures have been traded since the reforms of the 1930s. But because more money can be made trading on opaque, unsupervised markets, Wall Street objects to this reform. Once again, its leaders are attempting to subject Washington, and the country, to an insurmountable force.