Hirsh: The Coming Fight Over Re-Regulation

Amid the economic chaos of 2008, Arthur Levitt Jr. stands out. He's one of the very few regulators of the Clinton and Bush eras to take responsibility for the current financial disaster—to admit that he botched things, big time. "All tragedies in life are preceded by warnings," the former chairman of the Securities and Exchange Commission told me in an interview Tuesday. "We had a warning. It was from Brooksley Born. We didn't listen to that." Brooksley Born was the head of Commodity Futures Trading Commission (CFTC) under Clinton. Beginning in the spring of 1998, she pushed for the regulation of derivatives trading. She warned of the dangers of a vast global financial market that was going unchecked by governments. But she was silenced by the then all-powerful team of Federal Reserve Chairman Alan Greenspan and Treasury Secretary Robert Rubin. Levitt, who along with Greenspan, Rubin and Born was part of the four-person President's Working Group on Financial Markets, opposed her efforts as well. Today, Levitt says he was wrong. "It may well have been that the proposal was ill thought-out," says Levitt, who served as SEC chairman longer than anyone, from 1993 to 2001. "But we could have taken that opportunity to refine it, to make it forward-looking. I think that the explosive growth of a product that was unlisted and unregulated should have occasioned greater reaction."

Levitt's concerns go beyond assuaging his conscience about the past. Along with other financial markets experts, he is worried that the incoming Obama administration, populated with protégés of Rubin and Greenspan, may continue to resist the necessary regulation needed to restore confidence in Wall Street and prevent another subprime-type disaster in the future. While Levitt says he doesn't know what policies President Obama will pursue, he worries that the new administration will embrace the plan put forward last spring by Treasury Secretary Hank Paulson to consolidate regulatory financial authority loosely under the Federal Reserve Board, the Comptroller of the Currency and a merged SEC and CFTC.

Many experts say such a consolidation of authority is needed because the mortgage securitization phenomenon cut across so many formerly separate markets that no one regulator could keep track of it. Sometimes these regulators were virtually in bed with the industries they were supposed to be watching—as evidenced by the Treasury Department finding released this week that an official with the Office of Thrift Supervision helped IndyMac Bancorp, a giant California-based thrift that failed in July, cover up its financial vulnerability last May. The report by Treasury Inspector General Eric Thorson said that such protective actions happened more than once. In response, OTS Director John Reich said the official in the IndyMac case had been "reassigned."

But Levitt and other critics say the Paulson proposal is a fatally weak response to these problems, in part because it calls for "principles-based" regulation in which general guidelines are applied rather than specific rules. They say the plan would drain authority from the SEC and CFTC  at a time when both need to be beefed up, and it won't do enough to jump-start confidence in investors from Middle America to East Asia. "It's wishful-thinking regulation," says Levitt. "Regulation by hope rather than by design." Michael Greenberger, Born's former top aide at the CFTC, says the Paulson plan merely "circles around" the key reforms that are needed. "The Paulson plan arms the Fed to do rescue efforts. It makes it easier to chase the horse after it's left the barn, but does nothing to keep the horse inside," he told me. "Any plan that ignores the fundamental requirements of transparency, capital adequacy, antifraud and antimanipulation authority won't work. You can throw all the money in the world at stimulus proposals, bailouts, what have you, but if you don't form a concrete foundation that wards off the kind of conduct that's taken place up to now, the trust will never be restored. The American public wants to know that when it looks at a balance sheet, it understands what's happening." (Jennifer Zuccarelli, a spokeswoman for Paulson, said she could not comment on the record about the criticisms.)

Levitt told me that the unfolding Bernard Madoff scandal provides one more reason for reinforcing the SEC, and not allowing it to be subjugated to a "monolithic agency that has failed us in the past"—the Fed. Beginning in 1999, letters warning that Madoff was running a Ponzi scheme, especially those from Harry Markopolos, a securities executive, were neglected by the agency's Boston office. "Clearly some of the letters were sufficiently detailed that they shouldn't have died at the regional level," Levitt says. "The SEC has 400 inspectors who aren't terribly well trained and they have seven people in the office of risk management." You need a different kind of SEC, one that puts the priority of investors above all others. We've got to address investors who have this huge lack of trust in everything."

If the Obama administration doesn't act aggressively, a fired-up Congress may take the lead, and that will only add more confusion as different committees in different houses restrain the discretion of regulators, says Greenberger. Minnesota Democratic Rep. Collin Peterson, chairman of the House Agriculture Committee (which oversees the CFTC), is opposed to any effort to merge the SEC and CFTC, for example, and warns that creating a giant unilateral regulator could produce a bureaucratic nightmare like the Homeland Security Department. In the absence of serious reform by the Obama administration, European and Asian leaders will also push for tougher regulation—especially since their warnings to Washington were also ignored in the past. As recently as 2007, German Chancellor Angela Merkel, then head of the G7, proposed that international banks supply authorities with more information about their transactions. She "got her head handed to her by Bush and [then-British Chancellor] Gordon Brown and Paulson," says former IMF chief economist Ken Rogoff.

One question is how much former acolytes of Rubin's such as Gary Gensler, the nominee to head the CFTC, will rethink their former opposition to derivatives regulation. Gensler advised the Treasury Department on the drafting of the Paulson plan. The Obama transition team has failed to bring in aggressive champions of new regulation, critics say. Among those who have not been asked in: Born, Greenberger and Nobel Prize-winning economist Joseph Stiglitz, who was snubbed by the Obama transition despite his prescient warnings in the '90s that the financial system was out of control (and his early support for the president-elect). A leading member of the Obama transition team for financial issues, Tom Dohrmann, said he could not comment on why a Nov. 5 offer to Greenberger to join the team was dropped weeks later. Without those dissenting voices at the table, these critics fear, the new administration might be more likely to succumb to industry lobbying to minimize regulation. As recently as 2004, the SEC agreed to demands from Wall Street—made by, among others, Hank Paulson, who was then head of Goldman Sachs—to raise leverage ratios from 12 to 40, more than tripling the amount of capital they could bet.

Since Born's 1998 proposal, the market in derivatives—contracts whose value derives from an underlying asset like mortgages (or an interest rate or index)—has exploded from $30 trillion to more than $500 trillion, according to estimates by the Bank of International Settlements. By comparison, the entire U.S. economy produces about $14 trillion in goods and services annually. Yet these "over the counter" instruments were subject to no regulation even as bank after bank began to succumb to overloads of bad mortgage-backed derivative securities.

Rubin, in an interview with NEWSWEEK three weeks ago, said that he didn't support Born and other officials when they tried to impose more controls on derivatives because such regulation was "not politically doable;" the industry itself would have resisted it. Rubin also argued that he had long been concerned about derivatives trading and had supported large increases in margin requirements for derivatives, which might have restrained the market. Other former Rubin associates in the Clinton administration say that Born was "clumsy" about pushing her plan, and didn't do the necessary lobbying groundwork. "When you're actually governing, you're just crazed. There was so much going on then. Then someone comes up and says here's a nonproblem, why don't we throw everything at it?" says one Rubin loyalist who spoke on condition of anonymity. But even he admits that her proposal should not have been shot down so abruptly, and that "everybody kind of exploded at her."  Greenspan and the Clinton team continued to ignore her even in the face of the collapse of Long Term Capital Management, a giant hedge fund that almost caused a market meltdown when it collapsed under bad derivatives bets in 1998. Born did not return a call asking for comment.

A review of the CFTC's actual 33-page "concept release" at the time shows that Born had sought comment from different government agencies on how best to regulate derivatives. "We had no preconceived notions about how this should be done," says Greenberger, who served as director of markets and trading for the CFTC under Born. Levitt notes that Greenspan and the Clinton Treasury department were concerned that the proposal might affect the trillions of dollars in derivative contracts already executed, but he says that's a meager excuse. "Rubin and Greenspan were probably right in saying there were outstanding contracts thrown into uncertainty," he says. "But we could have grandfathered those and said that thenceforward we were going to regulate them." Greenspan was especially vehement in opposing regulation back then, say Levitt and others. In recent testimony to Congress, the former Fed chairman confessed his "shocked disbelief" that many of his assumptions about self-regulating markets—his "model"—had been overturned by the subprime crisis. But as yet there is no model to replace them.

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