The following guest post was contributed by Jennifer S. Taub, a Lecturer and Coordinator of the Business Law Program within the Isenberg School of Management at the University of Massachusetts, Amherst (SSRN page here). Previously, she was an Associate General Counsel for Fidelity Investments in Boston and Assistant Vice President for the Fidelity Fixed Income Funds.
Considering that much of the disastrous deregulation of the U.S. financial system occurred on President Bill Clinton’s watch, I was encouraged by his televised confessional Sunday. He admitted to Jake Tapper that he was led astray by two of his secretaries of the treasury, Robert Rubin and Lawrence Summers.
What an important and timely revelation. Admitting we have a problem is the first step to recovery. With financial rehab next up on the Senate’s agenda, it’s useful that someone is discrediting those who persist in promoting failed ideas. What to do about the $450 trillion (notional) over-the-counter (OTC) derivatives market will be at the top of the agenda. This is about big money. Really big. Industry began lobbying last year to protect the annual $35 billion haul that just five US banks bring in trading derivative contracts.
Reform ideas range from the most sensible recommendation by Professor Lynn Stout (return to a regime where naked credit default swaps are not enforceable), to Senator Blanche Lincoln’s very strong amendment (prohibiting the banks that have access to the Fed’s discount window from trading derivatives), to the necessary but insufficient (mandating all standard derivatives be cleared on exchanges and requiring collateral to be posted), to the weak (the current Senate bill, rife with exceptions).
Remember, this market includes potent credit default swaps, a key ingredient to the crisis. The existence of this $60 trillion (now $45 trillion) notional value market, protecting and connecting counterparties across the system, led to a $180 billion taxpapayer-funded bailout of AIG. And, as we have just learned, CDS played a central role inside the synthetic Abacus 2007-AC1 vehicle, a device that helped Goldman Sachs rob purchasers to pay Paulson.
Yet, in spite of the power of Clinton’s admission, or perhaps because of it, just after the interview with Tapper, Clinton counselor Doug Band swiftly dispatched a disclaimer. In a moment of blatant grade inflation, Band said that Clinton believed Rubin and Summers provided “excellent advice on the economy and the financial system.”
On some level, there is room for admiration. After all, Clinton appeared to own his own mistakes and rejected the Greenspan-Style Blame Game. Retrieving one’s advisors from under the bus and resuscitating their reputations may seem honorable. However, in the same breath, Band placed the blame solely on Greenspan’s “arguments against any regulation of derivatives.” This is nonsense. Greenspan was not alone on this.
Anyone who has watched the Frontline program on Brooksley Born, read 13 Bankers, or reviewed the 1999 report on the OTC derivatives markets by the President’s Working Group (for which Summers was a signatory) knows that Rubin and Summers gave Clinton very, very bad advice and also crushed any reasonable, dissenting voices. On page 16, the PWG report specifically states: “The sophisticated counterparties that use OTC derivatives simply do not require the same protections under the CEA as those required by retail investors.” It’s now time for Doug Band should issue a new update, in which Bill Clinton states that his original on-air recollection was correct.
Moreover, how could Summers’s championing Gramm-Leach-Bliley be considered “excellent advice”? When Jim Leach remarked upon GLB’s enactment, ”This is a historic day. The landscape for delivery of financial services will now surely shift,” it’s clear he had no idea how right he was.
Back to Clinton’s original confession. What was the fuss about? Let’s take a look. He revealed that concerning advice from Rubin and Summers on derivatives:
“I think they were wrong and I think I was wrong to take it because the argument on derivatives was that these things are expensive and sophisticated and only a handful of investors will buy them and they don’t need any extra protection, and any extra transparency. . . And the flaw in that argument was that first of all sometimes people with a lot of money make stupid decisions and make it without transparency. . . And secondly, the most important flaw was even if less than 1 percent of the total investment community is involved in derivative exchanges, so much money was involved that if they went bad, they could affect a 100 percent of the investments, and indeed a 100 percent of the citizens in countries.”
With these comments, Clinton, however vaguely, seemed to admit he was wrong for signing the Commodities Futures Modernization Act of 2000. It would have been nice if he explicitly apologized to Brooksley Born for not heeding her truly excellent, prescient advice. Among other things, the CFMA blocked the SEC from regulating credit default swaps as securities. And, it forbade the states from enforcing anti-gambling laws against those who bought credit protection without owning the underlying reference obligation.
Clinton’s words also challenged the conventional wisdom concerning the “sophisticated investor.” Much of our recent deregulation rested on the premise that sophisticated investors can fend for themselves and have the ability to select and monitor “private,” unregulated investment options, and that such investment choices only affect the direct owners, not underlying investors nor market integrity. Based upon the sophisticated investor myth, deregulators argued, successfully, that a wide swath of complex investment options did not need government mandated disclosure or substantive protections, such as restrictions on conflicts of interest. (I’ve covered some of this history in a draft paper, “Enablers,” and in “Recommendations for Reality-Based Reforms of Hedge Funds and Other Private Pools of Capital.”)
Clinton called attention to the imperfect performance of these so-called sophisticates when he noted that “sometimes people with a lot of money make stupid decisions” and they can affect us all. In light of the sad record of sophisticated investors to match up to the complexity and cunning of securities manufacturers and purveyors, it seems untenable to continue to believe that they can fend for themselves. Since and including the collapse of LTCM, the news pages have been filled with stories of institutions and individuals who meet the legal definitions of “sophistication” being duped or swindled.
One cannot forget that two such people who made “stupid decisions” with billions in other people’s money included Rubin and Summers. Notoriously, during Larry Summers’s tenure at Harvard, certain swaps were put in place; then, according to Nina Munks of Vanity Fair, “for reasons no one can seem to explain, the university simply forgot to (or chose not to) cancel its swaps. The result was a $1 billion loss.” (The decision about when to cancel the swaps took place after Summers had left Harvard.) And, then, there was Rubin, who, while a board member at Citibank, earned over $126 million, yet refused to take personal responsibility for the firm’s misuse of derivatives or lax oversight of mortgage underwriting for the loans it purchased.
Finally, the most galling thing about the sophisticated investor presumption is that the same individuals who promote the concept as a means for protecting the shadow banking system hide behind their own pseudo-ignorance, defending themselves for apparently not being able to properly select or monitor investment choices. Let’s hope they cannot have it both ways.