Were the Regulators Asleep on the Job?
The derivatives section of the FCIC report enters an area of controversy: did deregulation cause the crisis?
Let’s face it: You won’t read every page of the Financial Crisis Inquiry Commission report. But FrumForum will, over the next days. So let’s proceed together, page by page, identifying the key points.
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The derivatives section of the FCIC report enters an area of controversy: did deregulation cause the crisis?
As we have all been taught since 2008, derivatives originated in the trading of agricultural commodities. For that reason, power to regulate this trading was lodged in the Commodities Futures Trading Commission. The CFTC's supposed oversight failed to prevent a string of debacles in the 1990s. So the idea took hold that it might be better to leave the derivatives market alone, let it self-regulate. This view was shared not only by libertarians like Alan Greenspan, but by Clinton Democrats Larry Summers and Robert Rubin.
Thus, page 48:
In December 2000, 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 securities-based OTC derivatives such as stock options. In addition, the regulatory powers of the CFTC relating to exchange-traded derivatives were weakened but not eliminated.
The CFMA effectively shielded OTC derivatives from virtually all regulation or oversight.
Result, on page 48:
In the seven and a half years from then until June 2008, when the market peaked, outstanding OTC derivatives increased more than sevenfold to a notional amount of $672.6 trillion; their gross market value was $20.3 trillion.
These numbers are so preposterously big as to defy understanding. For context, consider that the entire annual output of planet Earth is estimated at $80 trillion.
CFMA is Exhibit A for those who wish to argue that it was "capitalism wot did it." That accusation has generated equally intense defenses from free-marketeers.
Yet no less a free-marketeer than Hernando de Soto has questioned whether it was right and appropriate to leave derivatives unregulated. Here's from an important (and under-appreciated) article he wrote about the crisis in the spring of 2009:
Look around: everything of economic value that you own—house and car titles, mortgages, checking accounts, stocks, contracts, patents, other people's debts (including derivatives)—is documented on paper. You are able to hold, transfer, assess and certify the value of such assets only through documents that have been legally authenticated by a global system of rules, procedures and standards. Ensuring that the relationship between those documents and each of the independent assets they represent is never debased requires a formidable system of legal property rights. That system produces the trust that allows credit and capital to flow and markets to work.
It is through paper that we connect and know the global economy. It is impossible to do business on a national level—never mind in a globalized marketplace—without reliable legal documentation. Yet this worldwide web of trust is now crashing down. In recent years, governments have debased paper by carelessly allowing into the market a biblical flood of financial instruments derived from bad mortgages nominally valued at some $600 trillion or more—twice as much as all the rest of the world's legal paper, whether it represents cash, traditional financial assets, or property, tangible or intangible.
The astonishing quantity of these documents, and the fact that they're so tangled up and poorly recorded, is making it difficult to determine how much there is, what it's worth or who holds it. Given that the volume of these derivatives dwarfs all other paper, the mess is also undermining one of the greatest achievements of property law: the power to identify and isolate with precision every asset and every particular interest on that asset. Thus a meager 7 percent default on subprime mortgages that were funded or insured by derivatives—maybe only a few hundred billion dollars worth of toxic paper—is debasing the rest of the economic paper and contaminating the entire economy. Because this toxic paper refers to credit and capital, it affects all economic activity; the loss of trust spares no one, spreading out in all directions and beyond local bubbles, whether subprime housing or dotcom. And then staring you in the face may be the worst recession in modern history.
This strikes me as exactly right - and no less right for the fact (full disclosure) that Hernando is a friend of mine, and that I helped him edit the piece.
More to come...