How Wall Street Defanged Dodd-Frank
Click to enlarge
‘My Guys Get Killed When Markets Are Opaque’
Perhaps no part of Dodd-Frank matters more than the CFTC’s battle to implement derivatives reform. Certainly the big banks wouldn’t argue that point: no product peddled by Wall Street has proved as lucrative in recent years, especially for the country’s most elite firms. Just five banks—Goldman Sachs, JPMorgan Chase, Citigroup, Morgan Stanley and Bank of America—account for more than a 95 percent share of a derivatives market that has been generating an estimated $40 billion to $50 billion in annual revenues. Because derivatives have been traded on dark (i.e., unregulated) markets, this “oligarchy” of five, says Darrell Duffie, a finance professor at Stanford’s Graduate School of Business and the author of How Big Banks Fail and What to Do About It, has been able to charge exorbitant rates to the wide range of businesses and government entities that buy them—profit margins that are sure to plummet if Dodd-Frank is fully implemented, Duffie says. That alone would justify the huge sums spent on lobbying to gut Dodd-Frank, a reflection of the banks’ unflinching resolve to protect the billions of dollars in derivatives profits they book every year. “If you look at the energy and ferocity and the dollars the financial sector put on the table, it was overwhelmingly directed at derivatives,” says Michael Barr, the former Treasury official.
This is why derivatives—and by extension, the CFTC—should matter to the rest of us as well, at least if we want to reduce the odds that the banks will again blow up the global economy anytime soon. It was derivatives, after all—all those credit default swaps, collateralized debt obligations and other exotic financial instruments that most of us would learn about in newspaper infographics offered only after the fact—that were the main culprit in the collapse of insurance giant AIG. They were also the main problem in the failures of Lehman Brothers and Bear Stearns, and nearly took down the other big banks as well.
Price manipulations of basic commodities such as oil and grains through derivatives are another target of Dodd-Frank, which instructs the CTFC to create “position limits”—caps on the portion of a market that financial speculators can own. The need for this check on financial speculators has never been clearer than in recent years, given the wild fluctuations in the price of oil in 2008, when a barrel of crude rose to $145 before whipsawing back to $37 in early 2009, and a spike in the price of wheat and other basic grains that caused rioting around the world.
The push to regulate a new breed of ever more complex derivatives goes back to the 1990s. The catalyst was the central role these instruments played in the financial collapse of Orange County, California, which in 1994 became the largest municipal entity ever to declare bankruptcy. Those in favor of derivatives reform would find their champion in Brooksley Born, who headed the CFTC under Bill Clinton. Think of most derivatives as a bet on the price of something going up or down—an interest rate, say, or mortgage defaults. Her agency was already in the business of regulating the futures markets for commodities such as corn and soybeans, Born argued, so why not add this new breed of financial derivatives to the CFTC’s portfolio? But this was in the Clinton era, when Democrats worked overtime to win the affections of Wall Street, and Wall Street knew that transparency would only spoil a good thing. Clinton’s top economic advisers, including Treasury Secretary Robert Rubin and Lawrence Summers, the deputy who would take his place in 1999, overruled Born and worked with Congress to pass what became the Commodity Futures Modernization Act of 2000, which had the effect of deregulating much of the derivatives market along with basic commodities like oil. Just eight years later, the world economy was in tatters, in no small part because of that decision.
Those championing derivatives reform were disappointed when President-elect Obama named Gary Gensler to head the CFTC in December 2008. Gensler was, after all, a Wall Street insider who had spent eighteen years at Goldman Sachs. Worse, he had served as assistant treasury secretary when the disastrous decision on deregulating derivatives was made. Given his years at Goldman, a central player in that market, Gensler was recused from participating in the debate during his first year in office, back when the Treasury Department was working overtime to stop Brooksley Born in her tracks. But he readily admits that he fought hard in favor of the Commodity Futures Modernization Act. His reasoning: the banks were already answerable to regulators, so why rope in another agency to monitor this one category of product?
Yet after watching what transpired, Gensler had a change of heart—and as Dodd-Frank was cobbled together in committee, Gensler fought his old colleagues at every turn. He proved willing to take on his fellow Democrats if it meant giving the CFTC more teeth to pursue reform, even causing a kerfuffle inside the White House when he sent a letter to Barney Frank and other committee chairs, calling on them to go further than the administration’s proposals in overseeing the derivatives market. “He’s shown that he’s no industry lapdog,” says Barbara Roper, the director of investor protection at the Consumer Federation of America.
Jim Collura, a lobbyist for a trade association representing home heating oil companies, has been similarly impressed by Gensler. Derivatives have understandably become a dirty word among the general public, but for the more modest-size businesses that Collura represents, they’re an essential tool for keeping price spikes in check. His companies routinely buy oil futures as a hedge against future increases in fuel costs. The airlines and trucking companies do the same so that gyrations on the global petroleum market don’t wipe out their profits. Municipalities are another common user of derivatives: an interest-rate swap can protect taxpayers against increased borrowing costs on a new convention center under construction. But the end users of derivatives also don’t want to worry that they’re getting ripped off every time they need to buy another swap. “My guys get killed when these markets are opaque,” Collura says, “and they get killed by out-of-control speculators.” After ten years of battle, Collura adds, and in large part due to Gensler’s pressure, “we got pretty much everything we wanted.”
But that, of course, was only halftime.