Greed

by D Thomas Jewett

  Chairman Greenspan sat at his desk with his hands folded together – listening. He interrupted the conversation and looked toward Jim, said, “Hi there. We are talking about Brooksley Born, the new head of the CFTC[11]. She claims her agency has the authority to regulate OTC Derivatives.”

  And then he turned and looked at Rubin. “Does she have that authority?”

  Rubin grimaced. “Yes.”

  “Damn!” The Chairman was clearly dismayed. “Well, she's outside of my chain of command; and yours' too. I think we may need to get Congress in on this.”

  Rubin's normally handsome face was about to explode. “I've got to tell you, I've received a lot of calls about her. The people I'm hearing from are well-heeled – people who tell me that trillions of dollars are at risk.” Rubin leaned forward and looked at Alan in earnest. “Alan, regulated markets are barely profitable. If she comes in and imposes regulations, the derivatives markets will be no more profitable than the other regulated markets – the banks' profits will suffer greatly.”

  Alan nodded his head in agreement. “Maybe we first should see if we can move her out of the way without going to Congress.”

  Rubin leaned back in his chair. “What do you have in mind?”

  “Let's have a meeting with her. Let's explain it to her.”

  “Okay. I like that.” Rubin stroked his chin. “What do you know about this woman – Brooksley Born?”

  “I met her. I invited her for lunch a while back. She was a contender for Attorney General before Janet Reno got the job. Heaven knows we probably would not have had Waco had she been the AG.”

  “And?”

  “Brooksley Born is an attorney and a financial regulator. She's brilliant. But I am not surprised that she thinks these markets need to be regulated. During our lunch, she as much told me she wanted to police against fraud.”

  Alan shrugged. “Like I said. She's a regulator. She believes in government intervention in the markets.”

  Left unsaid was the philosophy that both the Chairman and the Secretary lived by – that free markets are self-regulating and do not require government oversight.

  * * *

  Soon after . . .

  The limousine wound its way through the streets of Washington, D.C. Inside the limo, Chairman Greenspan and Jim Martin were talking – talking about Brooksley Born.

  “So, did Bob happen to mention how far along Brooksley is on her Concept Release?” Jim asked.

  “Somewhat. He said that Brooksley was already circulating it to regulators and trade associations. He wants to kill this quickly – and so do I.”

  “What's so bad about regulating the derivatives markets?” Jim asked.

  Alan looked at him and smiled. “Jim, you've been around me long enough to know my answer.”

  Jim smiled back. “Yes, I know. You believe that completely free markets are the most productive markets; and that markets are inherently self-regulating, requiring no government oversight.”

  “Correct,” Alan noted.

  “But,” Jim assumed a wry smile, “you've never explained to me how our markets can be 'totally free', as you put it, when we extend our heavy hand in setting an artificial price for money.”[12]

  Jim leaned forward. “What this means, Mr. Chairman, is that none of our markets are free, because one side of every transaction consists of money whose value is set by the Fed!”

  Alan looked at Jim and smiled. “You have a lot of credibility, which is why I asked you to attend. I urge you to stick to the issues in our meetings; and,” he paused, looking at Jim knowingly, “I want you to express your conclusions about imposing regulation in these OTC Derivatives markets.”

  Jim smiled. “Okay. If need be, I will make myself crystal clear.”

  * * *

  The limousine pulled up to the front of Treasury. Alan and Jim stepped out, entered the building, and made their way through the asphalt-tiled corridors; walking by one elaborate old wood doorway after another.

  Walking into the conference room, Jim noted that it was typical of federal government meeting chambers – the floor was a quality industrial padded carpet, and the walls were paneled in a medium-tone wood, probably birch. The sun was streaming through the windows.

  Jim looked around the room and noted that the main players of the President's Working Group were already seated – Larry Summers, Bob Rubin, and SEC[13] Chairman Arthur Levitt.

  Jim noted too that Brooksley Born, Chairwoman of the Commodities Futures Trading Commission was there. Since they had not previously met, he sized her up for the first time. Fifty-ish, with short dark hair, a broad mouth and penetrating eyes, she was attired in a white blouse and business suit. Her deportment exuded an understated power. She takes a back seat to no man, he mused.

  Alan greeted Brooksley and sat down beside her. Their manner seemed to be cordial toward each other, but an air of tension permeated the room.

  Bob Rubin opened the meeting. “This meeting is called to order.” He paused. “The purpose of this meeting is to discuss and provide input to the CFTC's proposed Concept Release for Over The Counter Derivatives.”

  “Chairwoman Born. Will you please provide an opening statement?”

  “Thank you, Mr. Secretary. I will be brief.” She paused. Putting on her reading glasses, she began reading from her prepared statement. “Currently, there is no government oversight or regulation of the OTC Derivatives markets. The CFTC possesses sole authority to regulate these markets, but so far has allowed them to function unfettered. We have observed a lack of transparency in these markets; and we believe that fraud is taking place. Because of this, we believe that oversight is necessary to protect the counterparties. But more important than this, we believe that leaving these markets without regulation will promote systemic risk – the risk that the unwinding of these markets could cause the entire economy to collapse.”

  “The Concept Release that we are proposing is a modest first step. It is intended to gather information about how these markets operate. It is not intended to promote the introduction of regulation into these markets.” She paused and looked around at the other attendees. “But for us to continue ignoring these markets means that we risk a collapse of the entire economy. Thank you.”

  The tension was palpable. You could cut it with a knife! Jim thought.

  Secretary Rubin replied. “Thank you, Mrs. Born.”

  Rubin paused and then continued. “Right after you began circulating the Concept Release, we received calls from a dozen or so large banks. These banks are telling us that your move is a threat to a major profit center. They also stated that your action to even contemplate regulation would cause widespread chaos in markets around the world.”

  Bob placed his hands on the table and leaned forward. “I'm here to tell you, Brooksley – you can't do this!”

  Brooksley raised her eyebrows and looked at Rubin. “Oh?”

  “Absolutely, Brooksley. You need to stop this now!” Rubin paused. “You can't do this. We just can't have it.” Rubin shook his head. “This deregulated market is part of what's brought us this economic boom; and we don't want to change that. The market will take care of everything. And we really don't need regulation of these markets – it would just be counterproductive.”

  “Well, Bob. I hear you. But I report directly to the President. You have no say over the CFTC or how it exercises its statutory authority.”

  Rubin sputtered. “Brooksley, your agency doesn't have jurisdiction over these markets.”

  An ocean of calm, Brooksley looked back into Rubin’s eyes. “Oh really? Bob, I have never heard anyone assert that we didn’t have statutory jurisdiction. I will be happy to review the legal analysis you're basing your position on.”

  “Fine, I will gladly provide an analysis from our law department. In fact, I am quite willing to have one of my attorneys come down to see you – I'm sure he can explain the law to you.”

  Arthur Levitt chimed in. “Brooksley, if you try to undo thes
e existing contracts, we will face a situation of financial turmoil the likes of which we’ve never before seen.”

  Jim could feel tensions rising as the meeting wore on.

  Alan had been sitting quietly, listening, and facing straight ahead. But the color of his face was crimson when he turned and looked at Brooksley. And unlike the Chairman we all knew, his voice quivered as he began speaking. “This is a serious, serious mistake. It will cause untold damage to the financial services market. You need to stop. You need to not do this.” He paused. “This is unwise, and it will cause tremendous damage.”

  Brooksley appeared to take Greenspan's comments at face value. She nodded but didn't respond.

  The meeting continued on for a while – with no let-up in tension. When it adjourned, it was obvious that the unstated mission of the meeting – to convince Brooksley Born to stop what she was doing – had failed.

  * * *

  Two weeks later, Born instructed her staff to publish the Concept Release. This caused an immediate and unprecedented response from the President's Working Group; and it attracted a visceral response from the financial community at large. Brooksley Born quickly found herself in a crossfire.

  Greenspan, Rubin, and Levitt responded immediately with this statement.

  DEPARTMENT OF THE TREASURY

  OFFICE OF PUBLIC AFFAIRS

  May 7, 1998

  RR-2426

  JOINT STATEMENT BY THE TREASURY SECRETARY,

  ROBERT E. RUBIN,

  FEDERAL RESERVE BOARD CHAIRMAN

  ALAN GREENSPAN

  AND

  SECURITIES AND EXCHANGE COMMISSION CHAIRMAN

  ARTHUR LEVITT

  On May 7th, the Commodities Futures Trading Commission (“CFTC”) issued a concept release on over-the-counter derivatives. We have grave concerns about this action and its possible consequences. The OTC derivatives market is a large and important global market. We seriously question the scope of CFTC's jurisdiction in this area, and we are very concerned about reports that the CFTC's action may increase the legal uncertainty concerning certain types of OTC derivatives.

  The concept release raises important public policy issues that should be dealt with by the entire regulatory community working with Congress, and we are prepared to pursue, as appropriate, legislation that would provide greater certainty concerning the legal status of OTC derivatives.

  In addition to the published statement, 'the powers that be' in the Administration also put out information to the mainstream media. The media immediately took the story and ran with it; characterizing the CFTC action as a power grab and further describing Brooksley Born as someone who did not understand the OTC Derivatives markets.

  Attacks were focused against the CFTC from all sides, leading to immediate hearings in Congress.

  * * *

  Four hearings were held over the summer. A Department of Agriculture Senate hearing, chaired by Senator Richard Lugar, set the tone for all of these hearings:

  Senator Lugar: “The hearing of the Senate Agricultural Committee is hereby called to order.”

  Excerpts from other participants ...

  “... today we will receive testimony on over-the-counter derivatives”

  “... it is essential that the government not create uncertainty ...”

  “... CFTC wants to come into somebody else's yard here ...”

  As Brooksley Born was pummeled, the hearing wore on ...

  Senator Phil Gramm: “I see no evidence whatsoever to suggest that this is a troubled market; that fraud is rampant in this market ...”

  Larry Summers: “... the Release has cast the shadow of regulatory uncertainty over a thriving market ...”

  Arthur Levitt: “... the CFTC's action has, and will bring I believe, significant disruption to this important global market ...”

  Alan Greenspan: “... serves no useful purpose, hinders the efficiency of markets, to en ...

  Senator Phil Gramm: “I feel very strongly that we should not have one agency innovate in this area; and in doing so, create very substantial financial problems.”

  And then from an unidentified Senator, this question was posed: “... my question, again, is what are you trying to protect?”

  Brooksley Born stood firm, saying, “We're trying to protect the money of the American public; which is at risk in these markets.”

  Ms. Born was head of a small, some would say, insignificant, agency. She was no match against the likes of Robert Rubin, Larry Summers, and Alan Greenspan; and their influence with a Congress already hostile to the CFTC's action.

  Congress departed on summer recess without finalizing a resolution ...

  * * * * *

  Jim Martin was home watching a movie when he received a telephone call – the call was from no less a personage than Chairman Greenspan himself.

  “Jim?”

  “Yes, sir. What can I do for you?”

  “I am sorry. I don't like to call you on a weekend; but especially on Saturday evening.”

  “That's all right, sir. What's up?”

  “We've got a situation. Long Term Capital Management is in the process of melting down.”

  “Melting down? Isn't that a little strong?”

  “Not in this case. They've been losing several hundred million a day.”

  Jim paused in shock. Mouth open, he ran his hand through his hair. “Wow!”

  Alan continued. “There is something I want you to do.”

  “Yes?”

  “I want you to provide an analysis of the effects on all of the markets if LTCM[14] collapses.”

  “Okay. Anything else?”

  “Yes. I also want an analysis on the effects to the economy should LTCM collapse.”

  “Got it. Anything else?”

  “Just one more thing. I'd like to know how much capital would be required to keep LTCM in the black. As part of this analysis, you may want to consider a sale of LTCM to some other entity; maybe a bank, or something like that.” Alan paused, then continued. “You'll probably need to get one of your microeconomics specialists – someone who's familiar with the investment industry – to run those numbers.”

  “When do you need this?”

  Alan paused for a moment. “We need it in time to save LTCM. So, as soon as you can get it to me.”

  “I'll get right on it.”

  “Thanks.”

  * * *

  Jim was at his desk early Monday when his telephone rang. “Jim Martin.”

  The Chairman's voice came across the wire. “What have you got for me?”

  Jim replied, “Well, the current market for OTC derivatives is about $27 Trillion. There are about 15 large banks who are heavily invested in it. And the leverage in this market is about 97%.”

  Jim listened as the line went silent.

  “Mr. Chairman?”

  “Yes, Jim. Would you please come on up? And please, bring all your notes.”

  “I’ll be there in ten minutes.”

  * * *

  “So,” Alan looked squarely at Jim, “what are the details?”

  “Well, sir – I’ve been in contact with Dale Martin over at the New York Fed. They’ve been tracking events with LTCM. The word is that LTCM has been bleeding a lot of money; much more than their worst-case mathematical models predicted.”

  Alan leaned back in his chair, touching his hands together at his fingertips. “Go on.”

  “So, LTCM specializes in risky arbitrage deals – very lucrative deals in U.S., Japanese, and European bonds. They’ve leveraged their bets with more than $120 billion in borrowed money – money they've borrowed from banks. They also carry about $1.25 trillion in financial derivatives. As you know, they’re considered rather exotic contracts and they’re only partly reflected on their balance sheet.”

  Jim looked at Alan pointedly. “Some of these contracts are highly speculative, and some are designed to insure LTCM's portfolio against whatever risk could be imagined.”

  “So – wh
at’s the core issue causing this?”

  “Well, sir. The oncoming Russian default is looking to be a huge problem for LTCM. It has caused a sea change in the markets so that LTCM’s models no longer work. The owners of LTCM are watching their $5 Billion in capital fly out the window.”

  Just then, the telephone rang.

  Alan pressed the speakerphone button. “Yes, Carol?”

  “I apologize for interrupting, Mr. Chairman. Mr. McDonough is on the line and wishes to speak with you.”

  Bill McDonough was President and CEO of the New York Fed – the same New York Fed that implemented the monetary policy decisions made by the Board of Governors and the FOMC. The New York Fed was also responsible for overseeing the financial markets.

  “Put him through please,” Alan responded.

  “Yes, sir,” Carol replied.

  And then Jim heard a click on the line.

  “Bill?”

  “Hi, Alan. How’re you doing?”

  “I’m doing well, Bill. But I think the question of the moment is, how are you doing?”

  “Not so well, Alan. This LTCM thing was a big issue. It has now become huge.”

  “How is that?”

  Jim thought he saw Alan’s shoulders tighten.

  “They’re bleeding like crazy, Alan. And their bleeding is causing them to dump their assets onto the market.”

  “So?” Alan replied. “They knew they were taking risks. Now they need to bear the consequences of their choices – don’t you think?”

  “For once, I must disagree.”

  The Chairman responded by raising his eyebrows.