Greenspan continued to champion derivatives and advocate deregulation of the OTC market and the exchange-traded market. "By far the most significant event in finance during the past decade has been the extraordinary development and expansion of financial derivatives," Greenspan said at a Futures Industry Association conference in March 1999. "The fact that the OTC markets function quite effectively without the benefits of [CFTC regulation] provides a strong argument for development of a less burdensome regime for exchange-traded financial derivatives."
The following year--after Born's resignation--the President's Working Group on Financial Markets, a committee of the heads of the Treasury, Federal Reserve, SEC, and Commodity Futures Trading Commission charged with tracking the financial system and chaired by then Treasury Secretary Larry Summers, essentially adopted Greenspan's view. The group issued a report urging Congress to deregulate OTC derivatives broadly and to reduce CFTC regulation of exchange-traded derivatives as well.
In December 2008, in response, Congress passed and President Clinton signed the Commodity Futures Modernization Act of 2000 (CFMA), which in essence deregulated the OTC derivatives market and eliminated oversight by both the CFTC and the SEC. The law also preempted application of state laws on gaming and on bucket shops (illegal brokerage operations) that otherwise could have made OTC derivatives transactions illegal. The SEC did retain antifraud authority over securitiesbased OTC derivatives such as stock options. In addition, the regulatory powers of the CFTC relating to exchange-traded derivatives were weakened but not eliminated.
Greenspan testified to the FCIC that credit default swaps--a small part of the market when Congress discussed regulating derivatives in the 1990s--"did create problems" during the financial crisis. Rubin testified that when the CFMA passed he was "not opposed to the regulation of derivatives" and had personally agreed with Born's views, but that "very strongly held views in the financial services industry in opposition to regulation" were insurmountable. Summers told the FCIC that while risks could not necessarily have been foreseen years ago, "by 2008 our regulatory framework with respect to derivatives was manifestly inadequate," and that "the derivatives that proved to be by far the most serious, those associated with credit default swaps, increased 100 fold between 2000 and 2008."
One reason for the rapid growth of the derivatives market was the capital requirements advantage that many financial institutions could obtain through hedging with derivatives. As discussed above, financial firms may use derivatives to hedge their risks. Such use of derivatives can lower a firm's Value at Risk as determined by computer models. In addition to gaining this advantage in risk management, such hedges can lower the amount of capital that banks are required to hold, thanks to a 1996 amendment to the regulatory regime known as the Basel International Capital Accord, or "Basel I."
Meeting in Basel, Switzerland, in 1988, the world's central banks and bank supervisors adopted principles for banks' capital standards, and U.S. banking regulators made adjustments to implement them. Among the most important was the requirement that banks hold more capital against riskier assets. Fatefully, the Basel rules made capital requirements for mortgages and mortgage-backed securities looser than for all other assets related to corporate and consumer loans. Indeed, capital requirements for banks' holdings of Fannie's and Freddie's securities were less than for all other assets except those explicitly backed by the U.S. government.
These international capital standards accommodated the shift to increased leverage.In 1996, large banks sought more favorable capital treatment for their trading, and the Basel Committee on Banking Supervision adopted the Market Risk Amendment to Basel I. This provided that if banks hedged their credit or market risks using derivatives, they could hold less capital against their exposures from trading and other activities.
OTC derivatives let derivatives traders--including the large banks and investment banks--increase their leverage. For example, entering into an equity swap that mimicked the returns of someone who owned the actual stock may have had some upfront costs, but the amount of collateral posted was much smaller than the upfront cost of purchasing the stock directly. Often no collateral was required at all. Traders could use derivatives to receive the same gains--or losses--as if they had bought the actual security, and with only a fraction of a buyer's initial financial outlay. Warren Buffett, the chairman and chief executive officer of Berkshire Hathaway Inc., testified to the FCIC about the unique characteristics of the derivatives market, saying, "they accentuated enormously, in my view, the leverage in the system." He went on to call derivatives "very dangerous stuff," difficult for market participants, regulators, auditors, and investors to understand--indeed, he concluded, "I don't think I could manage" a complex derivatives book. (pp.45-49).
A key OTC derivative in the financial crisis was the credit default swap (CDS), which offered the seller a little potential upside at the relatively small risk of a potentially large downside. The purchaser of a CDS transferred to the seller the default risk of an underlying debt. The debt security could be any bond or loan obligation. The CDS buyer made periodic payments to the seller during the life of the swap. In return, the seller offered protection against default or specified "credit events" such as a partial default. If a credit event such as a default occurred, the CDS seller would typically pay the buyer the face value of the debt.
Credit default swaps were often compared to insurance: the seller was described as insuring against a default in the underlying asset. However, while similar to insurance, CDS escaped regulation by state insurance supervisors because they were treated as deregulated OTC derivatives. This made CDS very different from insurance in at least two important respects. First, only a person with an insurable interest can obtain an insurance policy. A car owner can insure only the car she owns--not her neighbor's. But a CDS purchaser can use it to speculate on the default of a loan the purchaser does not own. These are often called "naked credit default swaps" and can inflate potential losses and corresponding gains on the default of a loan or institution.
Before the CFMA was passed, there was uncertainty about whether or not state insurance regulators had authority over credit default swaps. In June 2000, in response to a letter from the law firm of Skadden, Arps, Slate, Meagher & Flom, LLP, the New York State Insurance Department determined that "naked" credit default swaps did not count as insurance and were therefore not subject to regulation.
In addition, when an insurance company sells a policy, insurance regulators require that it put aside reserves in case of a loss. In the housing boom, CDS were sold by firms that failed to put up any reserves or initial collateral or to hedge their exposure. In the run-up to the crisis, AIG, the largest U.S. insurance company, would accumulate a one-half trillion dollar position in credit risk through the OTC market without being required to post one dollar's worth of initial collateral or making any other provision for loss. AIG was not alone. The value of the underlying assets for CDS outstanding worldwide grew from . trillion at the end of 2004 to a peak of $58.2 trillion at the end of 2007. A significant portion was apparently speculative or naked credit default swaps.
Much of the risk of CDS and other derivatives was concentrated in a few of the very largest banks, investment banks, and others--such as AIG Financial Products, a unit of AIG--that dominated dealing in OTC derivatives. Among U.S. bank holding companies, 97% of the notional amount of OTC derivatives, millions of contracts, were traded by just five large institutions (in 2008, JPMorgan Chase, Citigroup, Bank of America, Wachovia, and HSBC)--many of the same firms that would find themselves in trouble during the financial crisis. The country's five largest investment banks were also among the world's largest OTC derivatives dealers. While financial institutions surveyed by the FCIC said they do not track evenues and profits generated by their derivatives operations, some firms did provide estimates. For example, Goldman Sachs estimated that between 25% and 35% of its revenues from 2006 through 2009 were generated by derivatives, including 70% to 75% of the firm's commodities business, and half or more of its interest rate and currencies business. From May 2007 through November 2008, $133 billion, or 86%, of the $155 billion of trades made by Goldman's mortgage department were derivative transactions. When the nation's biggest financial institutions were teetering on the edge of failure in 2008, everyone watched the derivatives markets. What were the institutions' holdings? Who were the counterparties? How would they fare? Market participants and regulators would find themselves straining to understand an unknown battlefield shaped by unseen exposures and interconnections as they fought to keep the financial system from collapsing. (pp.50-51)
...Commission conclusion on Chapter 18 (September 2008: the bankruptcy of Lehman)
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