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Danger in Wall Street’s Shadows

By Frank Partnoy
New York Times
Friday, May 15, 2009

ON Wednesday, the Obama administration fired a shot across the bow of lobbyists — and their friends in Congress — who have been guarding against regulation of derivatives, the financial instruments at the center of the financial crisis. In a brief letter, Treasury Secretary Timothy Geithner suggested how new laws might help regulators oversee this $600 trillion shadow market.

For nearly two decades, derivatives have been at the center of every major financial calamity — from the bankruptcy of Orange County in California to Long-Term Capital Management to Enron to the recent subprime mortgage collapse. Yet over time, derivatives have become subject to progressively less regulation. Following the lead of the Federal Reserve chairman at the time, Alan Greenspan, both political parties in the 1990s agreed with Wall Street that derivatives should be permitted to grow unchecked.

Why are derivatives so problematic? Although they have useful purposes, particularly for hedging risks — as when an airline bets on increases in jet fuel prices — they frequently are used to avoid the disclosure rules applied to other financial transactions. A.I.G. held tens of billions of dollars of subprime mortgage-related derivatives, but did not tell its investors or counterparties.

Citigroup, Lehman Brothers and other banks used derivatives to place hidden trillion-dollar bets. Even now, numerous institutions are using derivatives to skirt investment restrictions or to take on unwarranted leverage.

This is an old story: during the 1920s, complicated techniques helped companies move risks off balance sheets or into off-shore subsidiaries. In response to the fall of Ivar Kreuger, the financier who pioneered these innovations, Congress adopted the securities laws of the 1930s, designed to plug two key regulatory gaps by requiring more disclosure and protecting investors against fraud.

Mr. Geithner’s proposal has the same twin goals: to improve disclosure and to police unsuitable sales of derivatives. These reforms are much needed. Banks might not have taken on so much subprime mortgage risk if they had been required to disclose it. Nor would they have marketed unsuitable products to pension funds and municipalities if they had more clearly been subject to liability.

Yet there is one potential weakness in the Treasury proposal, one that reopens a dangerous loophole. Mr. Geithner suggested that derivatives should be split between standardized instruments, which would be traded on regulated exchanges, and privately negotiated contracts, customized deals (often called “swaps”) that are made between two financial organizations and would not be publicly traded or regulated. Rather, such transactions would be reported privately to a “trade repository,” which apparently would make only limited aggregate data available to the public.

This proposal of Mr. Geithner’s also echoes history, but in a more dangerous way. In 1989, the Commodity Futures Trading Commission, a federal agency then led by Wendy Gramm, an economist and the wife of Senator Phil Gramm, a Texas Republican, issued a policy statement splitting derivatives into these same two categories. Standardized derivatives would be traded on exchanges, but individually negotiated contracts would not. Four years later, Ms. Gramm signed an order making this policy official, a sort of farewell gift to the derivatives industry before she left government service and took a place on Enron’s board.

The exception swallowed the rule, as regulators deemed more derivatives “individually negotiated.” In December 2000 Senator Gramm led a lobbying effort to cement his wife’s approach. It paid off: one of President Bill Clinton’s last official acts was to sign the law largely deregulating derivatives.

The leading derivatives lobbying group, the International Swaps and Derivatives Association, is already looking to exploit the Treasury’s proposal to split derivatives markets in two. As part of its lobbying campaign to protect negotiated instruments, it insists that last year “the derivatives business — and in particular the credit default swaps business — functioned very effectively during extremely difficult market conditions.”

Congress should not be fooled by such talk again. The current crisis is proof that although most people do not trade derivatives, everyone is subject to their risks. All derivatives, exchange-traded or private, must be in the sunlight. If institutions want to negotiate individual derivatives contracts, they should tell investors the full details of their exposure.

For decades, the American financial markets attracted capital because investors believed they were getting the information they needed. That faith has been shaken. To restore it, Congress should enact all of Mr. Geithner’s proposals, except one: it should not permit any private derivatives to grow in the dark. Otherwise, today’s exception will become tomorrow’s rule.

Frank Partnoy is a law professor at the University of San Diego and the author of “The Match King: Ivar Kreuger, the Financial Genius Behind a Century of Wall Street Scandals.”