This post was written by Simon van Norden of HEC-Montreal.
Brad DeLong is a very smart guy who writes something like 2,000 blog posts a year.
But I have to correct him on a recent one…..
The topic is financial regulation and what people knew in the 90s versus what we know now. Part of this is due to
President Clinton's recent remarks on his own failure to improve financial regulation. More narrowly, some people are also arguing about Robert Rubin's opinions.
Brad DeLong wrote
As I understand things, Rubin's position on derivatives regulation in the late 1990s had five parts:
- Derivatives should be regulated, with proper disclosure and capital
adequacy and information requirements, especially to protect
unsophisticated investors.- Phil Gramm is Chairman of the Senate Banking Committee, and
would always rather regulate less rather than more–and the House side
is even more so.- Brooksley Born and her organization are the wrong people to regulate derivatives.
- Derivatives should be regulated with a light hand, because
they are a small and specialized corner of financial markets and are
simply not large enough to pose any systemic threat.- The Federal Reserve has adequate powers to stem financial
crisis and keep it from becoming a threat to the economy, and is also
not worried about derivatives.As I see it, Rubin was correct on (1), (2), and (3). He was correct on (4)
when he was in office–when
derivatives were too small to pose any systemic threat to financial
stability. But that changed in the 2000s. And Rubin was completely,
utterly, and totally wrong about (5) (as was I).
The topic is catching on….Leonhart at the NYT notes it, as does
James Kwak at The Baseline Scenario.
Brad DeLong has his dates wrong. (4) and (5) were not shown to be wrong
in the 2000s. They were shown to be wrong on September 23rd, 1998 (and
Rubin served until mid-1999.)
That was the day that the Fed organized an orderly takeover of
Long-Term Capital Management's (LTCM) derivatives positions. There were two reasons they did so.
- LTCM
was technically bankrupt, and the Fed felt that a disorderly unwinding
of their positions could pose a systemic risk to the financial system.
Derivatives were key to LTCM operations; they gave the firm the
leverage necessary to make (and lose) billions.
- LTCM was a hedge fund, not a bank, or even an
investment bank or a dealer. The Fed felt that they did not have the
authority to intervene directly in the firm's affairs. Instead, they
orchestrated the firm's takeover by a syndicate of other Wall Street
institutions.
The first point shows that DeLong's (4) was wrong. The second point shows that DeLong's (5) was wrong.
Many people understood the implications of LTCM at the time. Some like
to point to the efforts of Brooksley Born. You could also look at the
1999 General Accounting Office report on LTCM.
To avoid subtlety, they titled it "Long-Term Capital Management:
Regulators Need to Focus Greater Attention on Systemic Risk." Reading
that report today, you can't avoid a feeling of déjà vu. One example:
- p. 41-42 "…by year-end 1998, LTCM’s leverage ratio was 21 to 1.
Because this leverage measure does not include off-balance sheet
activities, LTCM’s risk-adjusted leverage ratio would be even higher
given its off-balance sheet activities, such as its use of derivatives.
LTCM achieved substantial leverage, in part, through the use of OTC
derivatives because of low or zero initial margin requirements."
Recall that we've recently heard that, although major Wall
Street firms reported leverage ratios in the 20s just prior to the
crisis, this failed to reflect the fact that some were manipulating
their balances sheets (Lehman Bros. was using repos) to disguise even
higher leverage ratios.
People also worried at the time about the lack of clearing and
transparency in the OTC derivatives markets and urged that derivatives
trading be moved to exchanges. Those same problems came to the
forefront again in Sept. 2008. Looking back, you can understand
President Clinton's remorse that more wasn't done.
Worthwhile Canadian Initiative 
I believe “Smackdown” is the official term.
I think Brad has copyright on that……
Just a few weeks ago, he was complaining he couldn’t find enough “smackdowns”. This should please him!
Well put, Simon.
Well, you’re more right than Delong is, I’ll give you that Stephen. Here’s a couple of quotes for you,
“Consciously or unconsciously, we began to lift restrictions and to lower standards throughout the financial sector … General economic activity was drawn towards the financial sector by this explosion in ever-less regulated activities. Inventiveness concentrated itself on the creation of new, immeasurable financial abstractions – abstractions built upon abstractions – forms and levels of leverage which made the standards of 1929 seem tame by comparison … In this context, the traditional definitions of bank leverage no longer mean very much. … the American merchant bank Lehman Brothers had a capital base of $270 million. It had a daily exposure of $10 billion.”
That’s from John Ralston Saul, written in 1992.
Or try this,
“There is a substantial and growing basis for the conclusion of Felix Rohatyn, a senior partner with Lazard Freres & Co, that:
‘In many cases hedge funds, and speculative activity in general, may now be more responsible for foreign exchange and interest rate movements than interventions by the central banks.
…Derivatives…create a chain of risk linking financial institutions and corporations throughout the world; any weakness or break in that chain (such as the failure of a large institution heavily invested in derivatives) could create a problem of serious proportions for the international financial system.’
The fact that many major corporations, banks and even local governments have become active players in the derivatives markets as a means of boosting their profits began to attract the attention of the business press in 1994. The risks can be substantial, yet the institutions that have been major players generally do not disclose their financial exposure in derivatives in their public financial statements, preferring to treat them as ‘off-balance-sheet’ transactions. This makes it impossible for investors and the public to properly assess the real risks involved. The truth becomes known only as major losses are reported.”
That’s from David Korten in 1995, he goes on to list derivative related losses taken at Procter & Gamble, the Bank of New England, Paine Webber, BankAmerica, Orange County and Barings Bank, all cases that occurred in 1994-95. Noting that the Barings case was followed by a 4.6% fall in the Nikkei, he concludes, “That the actions of a single trader of no particular personal wealth or reputation could produce such a consequence is one of a growing number of indicators of the instability of a globalized financial system…”
By 1995 at the latest, the dangers were obvious to anyone paying attention and not blinded by adherence to free market ideology. Clinton could have and should have done more, but to be fair he would have been fighting against the spirit of the times.
To see what I mean, recall this old column from Paul Krugman,
“Consider the press conference held on June 3, 2003 — just about the time subprime lending was starting to go wild — to announce a new initiative aimed at reducing the regulatory burden on banks. Representatives of four of the five government agencies responsible for financial supervision used tree shears to attack a stack of paper representing bank regulations. The fifth representative, James Gilleran of the Office of Thrift Supervision, wielded a chainsaw.”
Sorry, I forgot to include a second quote from Korten who goes on to say,
“Typical is the position articulated by Thomas A. Russo, managing director and chief legal officer of Lehman Brothers Inc., a major investment house, in a New York Times op-ed piece,
‘…The evolution of financial products has not been followed by a regulatory evolution, and the mismatch has created problems … To add more rules to a system that was never designed for derivatives can only enlarge these problems. On the other hand, a complete overhaul of the system is politically unrealistic, The only remaining remedy: derivatives dealers and regulators should jointly formulate principles of good business practice for the industry. …’
Russo’s observation that the financial system has acquired such political power as to virtually preclude its reform is, of course, accurate.”
Again, that’s from 1995.