The U.S. economy and the stock market were booming on April 21, 1998, when the heaviest hitters of the Clinton administration met to discuss a controversial topic: whether the government should regulate a profitable but risky corner of the financial markets. Treasury Secretary Robert Rubin, the former Goldman Sachs co-chairman, attended. So did his deputy, Larry Summers, and Alan Greenspan, chairman of the Federal Reserve. The meeting’s odd woman out was Brooksley Born, the little-known chairwoman of a little-known agency, the Commodity Futures Trading Commission (CFTC), who exhorted her colleagues to consider regulating privately traded derivatives such as swaps contracts.
It’s no secret she lost. Her defeat that day left regulators not only powerless but clueless about the explosive growth in credit default swaps during the decade that followed, which allowed speculators to bet on an ever-rising housing market. The subsequent bust in 2008 caused the most devastating economic downturn since the Depression.
Now nine pages of handwritten notes from that pivotal meeting have emerged, documenting for the first time what happened behind closed doors. Written by an unidentified person in small, neat script, they were released by the Clinton Library on April 18, along with thousands of other pages of documents, but were largely overlooked in the media’s scramble for tidbits about President Clinton, Vice President Al Gore, and Hillary Clinton.
The notes are the raw material of a tragedy and show how an opportunity to head off distant calamity slipped away because of turf wars and a failure to communicate. Born saw herself as forward-thinking. Her opponents saw her as a loose cannon. Regardless of who was right, the result of their infighting was to arouse the Republican-controlled House and Senate, which ultimately passed a law that banned regulation of swap contracts.
Tensions among senior Clinton officials over regulating derivatives were already out in the open when the President’s Working Group on Financial Markets gathered at the White House for the April 21 meeting. Federal law required that futures contracts—promises to deliver something for a set price at a set time in the future—be traded on regulated exchanges. The law was less clear about other kinds of derivatives, such as swaps. In an interest rate swap, for instance, a party that wants to lock in a fixed rate agrees to exchange payments with another party that wants to pay a floating rate. These customized contracts were being traded privately between banks and were largely free of regulation. Born wanted to clarify whether and how the government would monitor and control transactions such as these to keep them from destabilizing markets. Others preferred to move more slowly.
In the notes, Born opens the topic by discussing what she called a “concept release”—a document that would ask a series of questions about possible regulations. “CFTC feels that they must go forward given how marketplace has evolved,” the note taker writes.
Rubin warns that the financial community is “petrified” that Born’s concept release implies swaps are futures. Because futures are required to be traded on exchanges, the implication would be that swaps not traded on exchanges are illegal and unenforceable. He says Born’s plan “raises uncertainty over trillions of dollars of transactions,” according to the note taker’s paraphrasing.
Born: “Why should looking at CFTC’s own regs. cause uncertainty?”
Rubin: “Massive concern.”
Arthur Levitt, then-chairman of the Securities and Exchange Commission: “Better ways to air issue.”
Summers: “Given that, rightly or wrongly, Treasury, Fed, SEC, & industry view concept release as being disastrous for market, is there not a better way to proceed?”
Then, a flash of emotion. Born is “pissed” about a breach of confidentiality: “(CONCEPT RELEASE WAS LEAKED!) by Treasury?” The word “pissed” is scratched out and replaced with “angry.”
Rubin: “Doesn’t disagree w/ substance of CFTC’s actions. Thinks there’s a better way to proceed.”
Born: “Rubin is asking CFTC not to uphold the law.”
Rubin: “Not suggesting CFTC not attain goal, but rather that CFTC find better approach toward attaining goal—one that does not carry such risks … legal staffs of various agencies should get together.”
Greenspan: “1992 hearings had consensus: not to deal with this issue (avert eyes & let it continue).”
Undaunted by the bruising debate, Born went ahead on May 7 with the concept release, stressing that it “does not in any way alter the current status of any instrument or transaction.” Greenspan, Rubin, and Levitt issued a statement the same day expressing “grave concerns” about the CFTC’s release. That helped persuade Congress to block the CFTC from changing its regulation of swaps.
Born resigned in June 1999. On Dec. 21, 2000, Clinton signed the Commodity Futures Modernization Act of 2000, which formalized the exemption of most over-the-counter derivatives from regulation as either futures or securities. Regulators were thus only dimly aware of the explosive growth in new products such as credit default swaps, which helped pump up the housing bubble and in 2008 brought down American International Group, then the world’s largest insurer. Interviewed in 2010, Clinton told ABC News that his economic team got it wrong—“and I think I was wrong to take [their advice].”
What could have been done differently? Born might have gotten better results if she had played the bureaucratic game with more finesse. Levitt, who’s now a senior adviser to the Carlyle Group (and a director of Bloomberg LP, which owns Bloomberg Businessweek), says he has gained an appreciation for Born but continues to think that her inquiry into the legal standing of derivatives such as swaps would have destabilized the market. “If you ask me now,” he says, regulating new derivatives—while grandfathering in old ones to avoid upsetting the markets—“would have been the right thing to do.” Rubin wrote in 2003 that he favored tighter regulation of derivatives but called Born’s way “strident.” Born has stopped talking about the episode.
Sixteen years after the debate detailed in those handwritten notes, regulators still haven’t completely nailed down the swaps market. The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 required that swaps where possible be traded on exchanges, but the CFTC is once again on the defensive. A bill in Congress seeks to weaken its power to regulate markets. Some U.S. banks are trying to get around CFTC rules by setting up affiliates overseas whose transactions they won’t have to guarantee. Somewhere an important meeting is happening, and with luck, someone is taking notes.