After The Fall: Saving Capitalism From Wall Street—and Washington

by Nicole Gelinas

At yesterday’s Financial Crisis Inquiry Commission hearings, Brooksley Born, one of the 10 commissioners on the Congressional panel, didn’t use her time taking cheap shots. Born, who ran the Commodity Futures Trading Commission (CFTC) under President Clinton, asked modest questions of Goldman Sachs chief Lloyd Blankfein. The details that she tried to uncover are the financial crisis, distilled.

Born confined her questioning to inadequately regulated, or “over the counter,” derivatives. It’s easy to see derivatives as peripheral to the “mortgage crisis,” but they were actually central to it. Derivatives are financial instruments that get their value from other securities or markets. When derivatives are properly regulated, traders must put a pre-determined percentage of cash behind their bets, right from the outset. A central clearinghouse holds that cash, along with cash from other investors. If one financial firm can’t pay its obligations, the clearinghouse can make good on the bankrupt firm’s promises. Risk-taking is robust within a controlled environment.

But over the past two decades, the financial industry created instruments that evaded these rules. Through unregulated credit derivatives, the insurer AIG made nearly half a trillion dollars’ worth of promises related to the value of mortgage-based and other debt securities. AIG and its trading partners, including Goldman Sachs, signed agreements that called for the insurer to make large, immediate cash payments that depended on sudden, unpredictable market moves—but AIG didn’t set cash aside for this purpose in advance.

When markets moved the wrong way, AIG couldn’t make good on the payments Goldman and others demanded. And because the contracts didn’t trade on central clearinghouses, nobody knew where the risk lay—and which other financial firms AIG’s default would bankrupt. These unknowns set off mass panic until the Fed and the Treasury announced that they would stand behind AIG’s promises, including those it made to Goldman Sachs.

Yesterday, Born honed in on unregulated derivatives’ role in precipitating the $182 billion AIG bailout, still the object of public wrath. Earlier that morning, Blankfein had testified that requiring derivatives to trade on central clearinghouses, with enforced cash-down requirements, would “do more to . . . reduce systemic risk” in the derivatives markets “than perhaps any specific rule.” Born asked Blankfein to explain unregulated derivatives’ broader role in the financial crisis—in effect, to explain why fixing this problem was so important, not just for derivatives but for the economy as a whole.

Blankfein then took refuge in generalities and absurdities. “Aspects of the over-the-counter derivatives market were a very, very big concern and a big worry,” he said: the generality. And then the absurdity: “My belief is that the derivatives market functioned actually pretty well under the circumstances. . . . We didn’t specifically have a derivatives crisis.” Blankfein’s evidence was that after Lehman Brothers, Washington Mutual, and a few other firms defaulted in September 2008, the holders of credit derivatives related to those banks’ failure managed to pay out on their obligations.

But Blankfein neglects a key point. Markets did this settling up after the government realized what a colossal disaster Lehman’s bankruptcy meant for the global economy. When Lehman made clear that it would file for insolvency on September 14, lenders to the world’s financial system stampeded for the exits. They did so partly because they were terrified that Lehman—and the then-flailing AIG—would owe a then-untold amount on derivatives markets and that payment wasn’t going to happen. They weren’t afraid just because Lehman had gone bankrupt; they were worried about who else would go bankrupt. The government muted the panic and saved the shell of the financial system only by pledging not to let it happen again. To prove it, the feds saved AIG the next day.

Born pushed Blankfein again to make the connections. “Do you think [with] the failure or near-failure of AIG, . . . do you think that having [central] clearing [of derivatives] would have . . . reduced the risks inherent in AIG’s position?” she asked.

Blankfein wouldn’t bite. “I believe that it may have helped a bit,” he allowed, explaining that a clearinghouse could have wrung cash payments out of AIG, which was “slow” in making them. But, he concluded, “AIG was bent on taking a lot of credit risk. . . . It was a failure of risk management of colossal proportion, and there were derivatives in there.” Without unregulated derivatives, the Goldman chief said, AIG “could have substituted other vehicles.” Blankfein failed to seize the opportunity to make a vital distinction: under a proper system of regulation, a bankrupt AIG would not have threatened the financial system.

Yesterday, a witness in the hearings’ afternoon session, J. Kyle Bass of an independent investment firm, Hayman Advisors, said what Blankfein should have said. “AIG, Bear Stearns and Lehman would not have been able to take on as much leverage as they did, had they been required to post initial [cash] collateral on day one . . . [I]n AIG’s case, they did not have to post collateral. . . . The so-called ‘initial’ margin was, and still is, only charged to counterparties that are deemed to be ‘of lesser credit quality.’” (AIG enjoyed near-perfect credit, until the firm used it to help bankrupt the financial system.)

Bass concisely offered solutions. Regulators should require derivatives participants—and presumably, participants in markets that haven’t been invented yet—to post “homogenous minimum collateral requirements” at the outset of their trades through a central clearinghouse “based upon a formulaic determination of risk. . . . This would prevent . . . an AIG-type scenario where hundreds of billions of dollars in risk is assumed with no cost.”

Note two of Bass’s words in particular. “Initial” is important. AIG’S trading partners did demand cash—but only after it became apparent that the securities against which AIG had made its promises were deteriorating. By then, it was too late. “Homogenous” requirements would protect the economy from the inability of the financial industry and the government to predict what’s risky in advance. If AIG had to put 10 percent down on its promises from the beginning, we would not have seen the panic that resulted from its fall. Market participants would have known where the risk lay and who was responsible for losses (the clearinghouse).

This lesson isn’t new. Born tried to get Congress to understand it more than a decade ago. After the Long-Term Capital Management hedge fund teetered in 1998, precipitating a government-led bailout of its lenders, she recognized the significance of what had happened. She concluded—correctly—that it was unregulated derivatives that had allowed Long-Term Capital Management to spin just $2.3 billion in investor capital into $1.25 trillion in potential liabilities without anyone noticing.

Just like AIG years later, Long-Term Capital Management and its lenders—the world’s biggest banks—avoided the rules that were supposed to ensure that bad financial bets could not imperil the economy. When Long-Term bet wrong, markets panicked. The world’s investors knew that the hedge fund couldn’t make good on its derivatives promises. Even worse was what investors didn’t know: which financial firms the hedge fund’s default might cripple. The New York Fed determined that markets couldn’t withstand the hedge fund’s bankruptcy. It forced banks to prop it up and then wind it down over time.

In the wake of this near-disaster, Born warned Congress that derivatives markets needed old-fashioned regulation. She told the House Financial Services Committee in 1998 that these markets posed “unknown risks to the U.S. economy and to financial stability around the world” because of their “lack of transparency” as well as “unlimited borrowing . . . like the unlimited borrowing on securities that contributed to the Great Depression.” But Washington and Wall Street saw the bailout as a success that proved they could handle these markets on a discretionary basis. So Congress, counseled by then-Fed chief Alan Greenspan, passed a law forbidding such regulation. A decade later, unregulated derivatives overwhelmed Wall Street’s ability to bail itself out.

If the Financial Crisis Inquiry Commission can get the American public to grasp just one thing, it should be that properly applying old rules to new financial instruments goes a long way toward solving the “too big to fail” problem that infects our economy and is at the root of public anxiety. AIG could not fail in 2008, because if it had, its unregulated derivatives would have blown up the financial system from the inside. The FCIC needs Congress, which has offered up a loophole-ridden derivatives fix, to get this, too. Otherwise, Wall Street will one day take on such mammoth liabilities that it overwhelms even Washington’s ability to bail it out.

Nicole Gelinas, a City Journal contributing editor and the Searle Freedom Trust Fellow at the Manhattan Institute, is a Chartered Financial Analyst and the author of After the Fall: Saving Capitalism from Wall Street and Washington.