Committee to Save World Repudiated by Successors
The three were hailed as the brightest economic minds of their generation, whose free-market solutions quelled the Asian financial crisis while generating economic growth of almost 5 percent in the U.S.
Yet their model of unfettered capitalism eventually invited disaster. The trio’s deregulatory approach encouraged banks to take risks that later threatened the U.S. financial system. A year before their magazine fame, they thwarted efforts by Brooksley Born, then-chairman of the Commodity Futures Trading Commission, to regulate the over-the-counter derivatives market, which ballooned to include the toxic instruments that ravaged American International Group Inc. (AIG) and Lehman Brothers Holdings Inc. Those decisions helped set the stage for the worst global recession since World War II, with aftershocks that are still being felt from Washington to Athens.
“They aggravated the financial excesses of the next decade by letting the commercial banks become like investment banks and run up huge amounts of leverage and acquire assets which they wouldn’t be able to do previously,” Edmund Phelps, winner of the 2006 Nobel prize for economics, said in an interview. “The ’90s were a time of triumphalism in Washington economic circles and in the American economics profession in general. Certainly Greenspan and Rubin and Summers didn’t help to combat that.”
Reining In Risk
The “committee’s” successors, including Treasury Secretary Timothy F. Geithner and Federal Reserve Chairman Ben S. Bernanke, are trying to rein in the risk that was allowed to build under their predecessors as they write rules under the Dodd-Frank Act of 2010, the most sweeping overhaul of the financial system since the 1930s.
“If these protections had been in place, then we would not have faced the risk of this severe a crisis with this much basic damage,” Geithner, 50, said at a Feb. 2 news conference to discuss the law. The U.S. had “allowed a very large amount of risk to build up outside the formal banking system without the safeguards we put in place after the Great Depression.”
Geithner was an assistant Treasury secretary in 1998 when the administration of President Bill Clinton was pushing for the deregulation of financial markets. The effort was led by Treasury Secretary Rubin and his deputy, Summers, along with Federal Reserve Chairman Greenspan.
On May 7, 1998, Born’s CFTC said it would consider whether over-the-counter derivatives should remain exempt from regulation. Before the end of that day, Greenspan, Rubin and Arthur Levitt, then-chairman of the Securities and Exchange Commission, put out a statement saying they had “grave concerns about this action and its possible consequences” and they “seriously question the scope of the CFTC’s jurisdiction in this area.”
Greenspan, Summers, Levitt and Born testified at a congressional hearing in July of that year, with the three men warning that the CFTC proposal could hurt financial markets and put the legality of existing derivatives contracts in doubt.
Born, a retired partner of law firm Arnold & Porter LLP in Washington, declined to comment.
The global OTC derivatives market mushroomed to a notional value of almost $600 trillion in 2007 from about $28 trillion at the time of Born’s proposal.
Government Steps In
Largely unregulated trades of those contracts helped fuel the 2008 financial crisis. The $182.3 billion U.S. bailout of insurer AIG starting in 2008 underscored the risks. AIG had run a business collecting fees by selling banks and other investors credit-default swaps, a form of insurance that would pay out if their mortgage securities defaulted. When the housing market collapsed, AIG was unable to meet its promises, and the government stepped in to honor the contracts.
Greenspan, Rubin and Summers also advocated repeal in 1999 of Glass-Steagall, the Depression-era law separating deposit-taking institutions from investment banking. The blurring of lines accelerated the growth of risky activities that often took place in the so-called shadow-banking system, outside the reach of bank supervisors.
“They didn’t see the danger coming from a combination of derivatives and the too-big-to-fail banks that were getting even bigger,” said Simon Johnson, a former chief economist at the International Monetary Fund and now a professor at the Massachusetts Institute of Technology.
Greenspan, in an interview, said blaming the crisis on lack of derivatives regulation and the repeal of Glass-Steagall amounts to a “rewriting of history.”
Credit-default swaps accounted for less than 1 percent of the derivatives market in the 1990s and weren’t discussed in meetings of regulators, he said. Glass-Steagall was “effectively eliminated” as far back as 1987 when courts allowed commercial banks to conduct some investment-banking activities.
“All the problems which are being attributed to the lack of bank regulation could have been contained by higher levels of capital,” Greenspan said. “You can’t forecast which products are going to fail or become toxic. You can, however, let banks do what they want to do over a broad range of activities, but require that they have enough capital to thwart default and contagion.”
The U.S. government committed $700 billion for financial firms, auto companies and programs to boost the housing sector, the centerpiece of an economic rescue that has run well into the trillions of dollars. “You have to address the issue of accountability for the policies that led us into danger,” MIT’s Johnson said. “The cost of cleaning it up is enormous, and we’re not out of it yet.”
Employment and housing markets in the U.S. are showing some signs of stabilizing after a drubbing in the recession that started in December 2007 and ended 18 months later. The unemployment rate in February held at 8.3 percent, the lowest in three years. The economy generated 227,000 jobs, capping the best six-month streak of payroll growth since 2006. Still, there remains a shortfall of 5.3 million jobs lost as a result of the recession.
Since the housing crisis began in mid-2006 during the George W. Bush administration, more than 4.2 million families have lost their homes to foreclosure according to RealtyTrac Inc. A rout in real estate prices has stripped $7 trillion from home values, according to the Federal Reserve. As a result, almost 11 million owners are paying mortgages that are bigger than their property values, as measured by CoreLogic Inc.
The Standard & Poor’s 500 Index closed at 1,392.78 yesterday, close to its highest since May 2008.
Aftermath of Meltdown
In the aftermath of the meltdown, the U.S. has less influence over how to resolve the European debt crisis than it did in the late 1990s when the “committee” was trying to stop Asia’s financial contagion. Finance ministers such as Germany’s Wolfgang Schaeuble chide the U.S. for spawning the subprime-mortgage debacle, while Occupy Wall Street movements around the globe protest the financial industry’s pay practices and lack of oversight by regulators.
In a Bloomberg Global Poll of investors taken in January, 71 percent said capitalism is in crisis, and 85 percent said there is at least some truth to the argument that banks are in need of regulation to prevent them from being too big to fail.
The “committee” missed warning signs and opportunities to impose “sensible regulation” on derivatives, leverage, failing banks, and the structure of the financial system, said Anat Admati, a finance and economics professor at Stanford University. “There were so many red flags,” she said.
Winding Down Firms
One was the near-collapse in 1998 of hedge fund Long Term Capital Management, which showed that “you must have a cross-border mechanism” for winding down large financial institutions, she said. “You could see the interconnectedness and how it plays out in a global system.”
In September 1998, LTCM received a $3.6 billion bailout from its Wall Street creditors in a rescue orchestrated by the Federal Reserve Bank of New York.
“All these things were clear and they, like many others, failed to see them,” Admati said. “We’re still dealing with the consequences.”
The three “were a lot too optimistic about the capacity of the financial markets to stabilize themselves and absorb shocks,” Robert Solow, winner of the 1987 Nobel prize for economics, said in an interview.
‘Prominent and Overconfident’
Still, he said, it’s “wrong just to blame three individuals who were prominent and overconfident.” If Greenspan, Rubin and Summers had “taken action about leverage, including in the shadow-banking system, there would have been an enormous outcry and they’d have been vilified from the other side.”
All three left government before the 2008 crisis. Since then, Greenspan, 86, has done consulting work for Deutsche Bank AG, Pacific Investment Management Co. and hedge fund Paulson & Co.
Rubin, 73, co-chairman at Goldman Sachs Group Inc. in 1990-92, was director of Clinton’s National Economic Council for two years before becoming Treasury secretary in 1995. He moved in 1999 to Citigroup Inc. (C), where he was chairman of the executive committee and made more than $120 million in a decade. He is now co-chairman of the Council on Foreign Relations and an adviser to Centerview Partners LLC, a New York investment banking advisory firm.
Summers, 57, who replaced Rubin as Treasury secretary in 1999, was president of Harvard University from 2001 to 2006. He later went to hedge fund D.E. Shaw & Co., where he was paid more than $5 million over 16 months before returning to the public sector to head President Barack Obama’s National Economic Council in 2009 and 2010.
Summers, asked after a Feb. 13 speech in Calgary whether regulators missed a chance to take action on derivatives that could have prevented part of the financial crisis, said “there’s no question that it would be better if the kinds of regulation that have now been put in place to ensure much greater transparency, much greater transparency on runs, much more reliance on exchanges, had been put in place earlier.”
“Just how much different the path would have been would depend on a large number of details,” he said. “It’s very hard to judge. It’s clear that we’ve learned a lot about the dangers of unregulated markets.”
Rubin declined to comment. At an April 2010 hearing of the Financial Crisis Inquiry Commission, created by President Obama and Congress to investigate causes of the financial crisis, Rubin said he wasn’t opposed to regulation of derivatives in the 1990s and agreed with Born on the risks of OTC swaps. He said he didn’t support Born’s proposal because it “could create legal uncertainty in the over-the-counter market” and lead to “chaotic conditions.”
In his 2003 book “In an Uncertain World,” Rubin said he thought derivatives should be subject to “comprehensive and higher margin requirements.” Rubin also told the inquiry commission that he supported the repeal of Glass-Steagall because the law had already been weakened since the 1980s to the point that “there were no restrictions left on what a large bank could do, except for insurance underwriting.”
Levitt, the former SEC chairman, said in an interview Feb. 15 that “it is a significant regret I had and have that I did not allow Brooksley Born to carry her recommendations further.”
Levitt said that the proposal to consider regulating derivatives would have cast legal uncertainty over outstanding contracts.
“But I should have insisted that we certainly should have regulated derivatives going forward,” Levitt, 81, said. “I don’t think it would have prevented the financial crisis, which was very largely a function of a dramatic drop in real-estate values and bad lending practices.”
Levitt, an adviser to Goldman Sachs and private equity firm Carlyle Group LP, is a Bloomberg LP board member.
Both the financial industry and regulators should have done more to curb the excesses, Donald Kohn, who spent 40 years with the Federal Reserve, including as vice chairman from 2006 to 2010, said in an interview.
“First and foremost, the private sector didn’t assess the assets it was buying very well, didn’t look under the hood very hard,” he said. “And the cops weren’t on the beat. Regulators saw some problems coming, but not all of them. I wish we had done more on the mortgage side, but especially on the financial-intermediary side. The private sector didn’t do enough and we didn’t override them.”
Greenspan, who was Fed (FDTR) chairman from 1987 to 2006, said in an interview that regulators didn’t have “leeway to do terribly much differently from what we did.”
He referred to a speech he gave in 2000 when he said, “We do not, and probably cannot, know the precise nature of the next international financial crisis. That there will be one is as certain as the persistence of human financial indiscretion.”
“Such statements elicited little response,” Greenspan said in the interview. “It is very difficult to go against the culture of the time.”
A lingering effect of deregulation and the crisis that followed is that other nations have become more skeptical of the U.S. on financial issues. With a budget deficit of $1.3 trillion last fiscal year and an economy still in recovery, “the U.S. isn’t in a position to dictate terms,” said MIT’s Johnson, co-author of “13 Bankers: The Wall Street Takeover and the Next Financial Meltdown.”
Taking a Shot
Schaeuble, Germany’s finance minister, took a shot at the U.S. in remarks in October amid discussion of Europe’s debt crisis. It wasn’t a “pure coincidence” that the bankruptcy of Lehman Brothers “had its origins in the U.S. with the subprime crisis,” he said.
Geithner has said European leaders seek his advice.
“They want to learn from the mistakes we made and the things we got right,” he said during a Jan. 25 Bloomberg Television interview.
A diminished U.S. stature is seen at international forums such as the Group of 20, Greenspan said. Before the crisis, “the United States was always the prime mover within those groups, clearly the leader. That’s been lost.”
U.S. economic strength has declined relative to faster-growing nations in Asia, and “to a very large extent that has translated almost immediately into its impact on influence,” Greenspan said.
The Obama administration faces a different set of challenges than Clinton’s during the Asian crisis starting in 1997, Summers said in an interview in January.
“European countries are major industrial countries with a set of political institutions knitting them together, and therefore there’s less role for anything external than there was,” Summers said.
At the same time, “The mood around the United States is kind of different,” he said. “There’s more of an orientation to a softer, more multilateral approach.”
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