by Ron Suskind
Now Cantwell pressed Geithner.
CANTWELL: I want to go back to the regulatory reform issue, because it’s so important. A former SEC chairman, Mr. Levitt, basically describes the CMFA, the credit—I mean the Commodities [sic] Futures Modernization Act—as—at least in the way he was talking about derivatives and credit default swaps—as a failure. Would you agree?
GEITHNER: Senator, I—a lot—a lot can . . .
CANTWELL: I’m sorry. I’m sorry. He used the word “mistake.”
GEITHNER: It was a mistake? I don’t think I agree with that, but I do agree that we’re going to have to take a very careful look at the whole comprehensive framework of requirements, regulations, constraints, and incentives that exist for the institutions that play a central role in those markets.
We want to make sure that the standardized part of those markets moves into a central clearinghouse and onto exchanges as quickly as possible.
Clearinghouses and exchanges. No one seemed to take much note, and Cantwell pressed forward to her next question.
Later that afternoon, in his temporary office at the Treasury Department, Gary Gensler trolled the newswires about the Geithner hearings.
Gensler knew that the White House would put all its weight behind the confirmation of Geithner and Summers. Their nominations might be called “too big to fail” in a time of crisis. For Gensler, only limited political capital would be expended.
Once a top economic adviser to Hillary Clinton, Gensler had been hustling to get a key spot on the Obama team since a few days after Clinton’s concession in June 2008. If nothing else, since then, Gensler had been scoring high marks for indefatigable effort, having worked to raise money for Obama on Wall Street, gathered endorsements from nearly three hundred CEOs, and, after the election, rushed to Chicago to help in any way he could with the transition.
Beyond his long history with Hillary, Gensler’s problem was he carried the scarlet letters “GS” on his chest: Goldman Sachs. Just as academia had watched Larry Summers rise meteorically through its ranks, the banking industry had seen in Gensler its own shooting star. By age thirty, after an MBA from Wharton, he’d made partner at Goldman, one of the youngest in the firm’s history. His eighteen-year career at the firm would wrap up by the time he was forty, as co-head of all Goldman’s financial operations. That’s when, in 1997, his longtime mentor, Treasury secretary Bob Rubin, persuaded him to come to Washington as, first, assistant secretary for financial markets, then undersecretary of domestic finance—jobs that oversaw the U.S. financial markets, government-sponsored enterprises such as Fannie and Freddie, federal lending, and the government’s fiscal affairs.
One notch above Gensler, throughout, was Larry Summers. Down the hall, as a peer, was Tim Geithner. But Gensler had experience, having actually run the profit-gulping machinery of Goldman, that neither man could match. So, in 1998, when a Greenwich, Connecticut, hedge fund called Long-Term Capital Management—boasting two Nobel Prize winners—found itself on the wrong side of gargantuan derivatives bets on foreign currencies, it was Gensler who raced from a Rosh Hashanah dinner in Washington to get on a plane. What he found, of course, was a first harbinger of coming disasters. He called Rubin, then Treasury secretary, to tell him that the exposure of the rest of Wall Street to losses from LTCM could collapse credit markets. Soon, Wall Street titans gathered and agreed to share losses from LTCM and avert a widening crisis.
But Gensler, also involved in the late-1990s actions undercutting Glass-Steagall and the regulation of derivatives, was, by 2002, moving against the Clintonites’ antiregulatory stance. Already independently wealthy, he assisted a longtime friend, Maryland senator Paul Sarbanes, in constructing what would become the Sarbanes-Oxley Act, legislation—reviled across corporate America—that mandated rigor and CEO accountability in the public filing for companies and heavy fines in the event of failure.
This long record of public service and enthusiastic recent efforts on behalf of Obama was just enough to boost Gensler, the son of a vending machine operator from Baltimore, to a modest slot on the ladder of appointments: chairman of the Commodity Futures Trading Commission, or CFTC.
The commission, originally created in 1974, was designed to take over responsibilities housed in the Department of Agriculture to regulate the trading of futures and options on a wide array of commodities, from cotton, corn, and wheat to meats and precious metals. The trading of futures contracts—which would eventually grow into the vast derivatives market of financial instruments—has a long history, with citations about the future delivery of products at a certain price dating back to Aristotle. In nineteenth-century America, when shortages or surpluses of agricultural products caused chaotic fluctuations in price, Chicago businessmen developed a market that allowed grain merchants to trade “cash forward” or “to arrive” contracts that they could use to insulate, or hedge, themselves against price changes. The problem with such contracts, which at the time were often handled as private, two-party agreements, is that they wouldn’t be honored by a buyer or a seller if a price fluctuation were not to their liking. The Chicago Board of Trade was formed in 1848 to be an open, transparent market where such contracts could be traded and legally honored, and soon the contracts—which derived their value from some underlying asset, such as bales of wheat—were themselves standardized.
While futures exchanges such as the Chicago Board of Trade established transparent and orderly platforms for trading these contracts, a separate issue of later “clearing” the trades (much in the way parties at a title company meet to “close” on the sale of a house) was taken up, starting in 1883, by clearinghouses, for-profit firms that then proliferated. Clearinghouses (or, in a few instances, the exchanges themselves) stepped briskly into a natural role, assuming, for a fee, the “risk” of a trade by first ensuring that the parties to a transaction had enough capital—money that they’d often have to post with the clearinghouse—to cover any foreseeable outcome on the trading floor.
This structure, which stayed sound and largely unchanged for nearly a century—even with some wild panics and swings in the prices of everything from gold to pork bellies—began to change in the 1970s with the development of financial futures. These allowed the trading of contracts on future fluctuations in interest rates. This market grew in fast evolutionary leaps for two decades, spreading to all manner of financial products, as the CFTC, built to deal with futures on the bales or barrels that eventually got delivered to someone, at a designated price, struggled to keep up.
A showdown of sorts occurred in 1998, when the CFTC’s commissioner, Brooksley Born, said that something must be done to better regulate that already sizable world of financial derivatives. Born, once a pioneer in her own right as the first female editor of the Stanford Law Review, found herself across the table from a group of unsympathetic men: virtually every senior financial figure or regulator of that era, from Rubin and Summers to Alan Greenspan and then-SEC chairman Arthur Levitt. The financial services industry had been fighting with strength and success for more than a decade to keep their flash-fire terrain of financial derivatives separate from the rules—such as collateral and clearing requirements or standardized contracts and open trading exchanges—that governed the trading of sleepy “tangible” products. As the Internet was exploding, the financial services industry was developing its own virtual world of bets and swaps and hedges on the future prices of anything that could be stamped as having financial value, from a piece of paper to a promise. Born was unconvinced by their pitch of having created a brave new world. A financial product was still a product, she asserted, every bit as sensitive to issues of price discovery, fair dealing, credit and collateral, shortages, gluts, and market panics as were silver or soybeans. Larry Summers, leading a regulatory vanguard of men, disagreed and was soon on the phone, from his office as deputy Treasury secretary, “with thirteen bankers.” He brusquely lectured Born, telling her that her ideas for regulating financial derivatives were “go
ing to cause the worst financial crisis since the end of World War Two!” The next meeting was face-to-face with all the men—including the trio of Greenspan, Rubin, and Summers—who said she must cease and desist. They said a golden age was dawning, in which sophisticated investment houses had created new, ingenious ways to manage risk. Born stared them down, quiet, sober, and unmoved. She’d spent her whole life as the lone woman in rooms of supremely confident men; she wouldn’t budge. After the meeting, the Clinton administration’s regulatory barons, egged on by Wall Street, went to Congress and had her agency neutered.
What followed was a Cambrian explosion of derivatives traded OTC, or “over the counter,” in the dark pools managed by the investment banks, large commercial banks, and related financial firms. The derivatives could be crafted—by teams of beautifully compensated lawyers—to fit the needs of any company’s balance sheet or the performance expectations of any fund, and then sold off to others as “investments,” opening the way for enormous leverage and speculation to flow, often unwittingly, into the financial system. The firms were the matchmakers, finding one party whose need fit another’s desire, and then charging each counterparty a fortune.
Gensler was now sitting in Born’s chair—his second day on the job—though, before confirmation, he’d be in a temporary office inside Treasury. He understood as well as anyone in government the ins and outs of what they’d done in the late 1990s, and what drove the derivatives bonanza. Gensler always felt a touch of competitiveness with Geithner. They were friends who’d come up together under Clinton, but Geithner had never been an undersecretary, and if Hillary had won, Gensler might now have been in Geithner’s shoes. What’s more, after all his hustling, a hard fact—noted in the transition team’s secret blueprint for regulatory reform—was the new administration’s stance on the CFTC: that it should be folded into the larger SEC.
In short, Gensler was hustling for a job that had been slated for termination. And the displeasure that Maria Cantwell voiced to the administration weeks before about the nomination of Geithner was even more acute on the subject of Gensler, a Goldman Sachs alumnus who would now be overseeing the derivatives market that Goldman had so profitably, and disastrously, gamed.
Then something caught Gensler’s eye: a passing reference in a wire report about how Geithner had said, in response to Cantwell, that he was fully supportive of moving the standard part of those derivatives markets onto central clearinghouses and exchanges as soon as possible.
Gensler did a double take. Exchanges? Clearinghouses were in the regulatory blueprint they’d come up with during the transition. But not exchanges.
What Gensler knew was that Wall Street felt it could manage the “central clearing” that Geithner had mentioned that morning. Customers, or end users, trading financial derivatives would have to turn to clearinghouses, just like traders and hedgers of traditional commodities, to settle transactions and trading positions at day’s end. This would mean that the issue of collateral would come up, especially if some counterparty were dangerously exposed on the wrong side of a trade, derivatives contract, or swap. This ensured a bustling growth curve for clearinghouses, accountants, lawyers, and the like. Though the clearinghouses would still operate in the dark pool, regulators would have a chance to nose around in their books to spot a perilous exposure that could melt the financial system, the sort of “systemic risk” Gensler found that day in 1998 when he visited Long-Term Capital Management.
But to force financial derivatives onto exchanges? Though it sounded innocuous, a push to standardize derivatives and force them onto open trading platforms is what Wall Street secretly, and rightly, feared.
If the particulars and prices of derivatives contracts and trades were posted like transactions on the New York Stock Exchange, it would destroy the fat margins banks made charging fees on these derivatives deals. As it stood now, only the middleman banks knew both sides of any deal, and this information advantage was powerful. Where buyer and seller were blind, the banks ruled, and they profited wildly—estimated to generate nearly $40 billion in profits a year—from their stranglehold on the derivatives cartel. The market for the most lucrative, customized over-the-counter derivatives was controlled by five large banks.
This opaque arrangement, the very opposite of an “efficient market,” is what made derivatives so profitable—which cartels often are—and dangerous. It was also the information advantage, the financial equivalent of classified information, that prevented regulators, and the wider marketplace, from seeing the depth and nature of various banks’ exposure. This information could well have laid bare the ballooning problem of mismanaged risk, which in turn could have led to preemptive actions that would have headed off the financial crisis. Instead, invisible risk grew, impelling Warren Buffett to call derivatives “financial weapons of mass destruction.” Like their battlefield equivalent, they combined secrecy with terrible destructive capability. Forced to be standardized and placed on exchanges, derivatives would soon be conventional products and Wall Street would lose its most prized profit center.
Gensler sat at his desk wondering what to do. Geithner and Summers, like many seasoned regulators and economists of this era, often appeared to understand the financial markets better than they actually did.
Did Geithner realize he’d just declared war on Wall Street? Even if it hadn’t been picked up in the press, it was certainly something the lobbyists for the big banks wouldn’t miss.
He walked a few doors down to Geithner’s office.
“Tim, got a moment?”
In the late 1990s, Geithner would sometimes double-check his grasp of financial market intricacies against Gensler’s long experience with an “oh, by the way” nonchalance.
Now it was Gensler with the question.
Geithner looked up: “Yeah, what’s up?”
“I saw a wire story where you had that give-and-take with Cantwell. On the derivatives, you said you wanted derivatives in clearinghouses and trading on exchanges. Is that right?”
Geithner nodded. “Yeah.”
“Great. I just wanted to make sure you said both, because I’ll need to say the same thing.”
“That’s what I said,” Geithner replied, and then turned back to his work.
Back in her office in the Dirksen Senate Office Building, Maria Cantwell huddled with her top aide on financial reform. Leaving the confirmation hearing that morning, he’d turned to her and said, “Did you hear what he said—he said clearing and trading on exchanges. That’s huge.” Cantwell was perplexed, unaware of the distinction and not sure she’d heard the word “exchanges” in any event.
Now the two of them looked over the transcript. There it was: “exchanges.” Her aide then briefed Cantwell on the nuances of what it meant to try to standardize the customized world of derivatives and push them onto transparent trading platforms. It would kill Wall Street’s margins. The sunlight of exchanges would cut out the middleman: firms could simply post their “ask” on some standardized derivatives contract—just like someone buying or selling stock—and see what kind of offer they got. They could compare prices and take the lowest one. The handcrafted derivatives product itself would be demystified and out in public, which would kill some of its less-than-pure appeal to clever corporate treasurers or fund managers.
Cantwell immediately got it. The next day, as the Finance Committee was about to convene to vote on whether they would recommend Geithner’s confirmation to the full Senate, she called up Geithner’s office.
“Yesterday, when you were testifying, did you really mean to say you want to push derivatives onto exchanges?” she asked.
Geithner paused. “No, actually I didn’t,” he said sheepishly.
Cantwell laughed under her breath. “Well, at least you’re honest—I respect that.”
Of course, she had Geithner testifying to mandatory exchanges under oath, as a condition of his confirmation, and now she could press Gensler to say the same when his turn came.
The Finance Committee hearing soon started. Though Baucus had cut his deal with a wildly popular president, some of the members couldn’t resist speaking their minds.
“I am disappointed that we are even voting on this,” said Senator Michael Enzi, the Wyoming Republican who, in general, had good relationships across the aisle. “In previous years, nominees who made less serious errors in their taxes than this nominee have been forced to withdraw.”
Even Kent Conrad said that he would have voted against Geithner in normal times, but “these are not normal times.”
So, in the latest twist of an improbable journey, Tim Geithner, after many disastrous instances of commission and omission in both the Clinton Treasury and the New York Fed, would now be saved from the ignominy of a failed nomination by the crisis itself.
As for Maria Cantwell, she voted yes as well—helping to recommend Geithner’s confirmation to the full Senate by a vote of 18 to 5—because he admitted to a mistake. Not on the big issues of altering regulation in the late 1990s, which had helped unleash financial demons, but on a smaller issue of not knowing what he was saying under oath.
Less than a week into office, Barack Obama knew he had to make to a decision. The promise he’d made to Peter Orszag and others about fundamental health care reform being his top priority for year one needed to be reexamined.
The earth was shifting quickly beneath the White House, as it was beneath the feet of every American. Figures showed that the U.S. economy had lost nearly six hundred thousand jobs in December. January was looking just as bad.
