All the Devils Are Here

by Bethany McLean; Joe Nocera

  As a female law student in the early sixties, Born had faced her share of slings and arrows. When she became the president of the Stanford Law Review—the first woman to do so—a dean told her that “the faculty stood ready to take over the law review if [she] ever faltered,” as she later recounted in the Washington Post. Although she graduated first in her class—another first for a woman at Stanford Law—the school declined to recommend her for a Supreme Court clerkship. She wangled tea with Justice Potter Stewart, who told her point-blank that he wasn’t ready for a female law clerk.

  Perhaps as a result, she had a steely side. Though always polite and cordial and collegial, she was tough when it came to things she cared about. She took her new post with the same resolve that had long characterized her.

  It wasn’t long before she was focusing her attention on derivatives. In the years since Wendy Gramm had ruled that they didn’t constitute futures, the business had exploded. Sumitomo, a large Japanese commodities dealer, had been caught using over-the-counter derivatives as part of an effort to corner the copper market. The Procter & Gamble and Orange County debacles were still fresh on people’s minds. After she had been in office for a while, Born also began to hear rumors that firms were using swaps to doctor their quarterly financial statements.

  As she looked more closely, she realized there was some question as to whether the grounds for the Gramm exemption still applied. After all, it was only supposed to pertain to one-of-a-kind derivatives between sophisticated counterparties. Yet swaps had become so commonplace that many of them were practically standardized and used off-the-shelf contract language. If derivatives were becoming standardized, Born wondered, shouldn’t they also be traded on exchanges? Shouldn’t they be classified as futures? And shouldn’t they be regulated?

  Although the Sumitomo market manipulation case had been exposed before she took office, the agency conducted its investigation—and imposed a hefty fine—on Born’s watch. The experience made her realize that “we were trying to police a very rapidly growing part of the market for manipulation and fraud, but we knew nothing about the market,” she later said. “There were no record-keeping requirements. No reporting requirements. It was totally opaque.”

  Born was in many ways a political naïf. She ran an agency with fewer than six hundred employees. She lacked both the power base and the political skills to sway members of Congress or her fellow regulators. All she knew was that derivatives were a gigantic market and that some bad things had happened in the past, and that meant, in all likelihood, that bad things might very well happen in the future. And no one in the government had a clue. Born and others at the CFTC started calling derivatives “the hippopotamus under the rug.”

  About a year into her tenure, Born hired a top Washington litigator, Michael Greenberger, to be the director of the CFTC’s division of trading and markets, which made him one of her top deputies. The hiring itself suggested what a tin ear she had for politics: Greenberger had never been involved in commodities, and so had no natural allies on the agriculture committees that oversaw the CFTC. He and Born had gotten to know each other serving on the board of an agency that helped the homeless. But he was no rube—he had spent his career involved in complex litigation and had argued several cases before the Supreme Court. Like his new boss, he also knew how to be tough when he needed to be. Not coming out of the commodities industry, he later said, gave him an advantage over just about anyone else who might have taken that job. “Because I was not dependent on the futures business, I really did not care what the futures industry thought of me.” Not long after he came on board, Greenberger had a meeting with Born. “I remember her telling me that we have a lot of things to do, but that I had to start focusing on over-the-counter derivatives,” he says.

  Thus it began.

  That Bob Rubin worried about derivatives was not the result of some conversion experience that took place after he joined the government. He had felt the same way during his years on the fixed-income desk at Goldman Sachs. It’s not that he hadn’t traded in derivatives—what was an option, after all, but a kind of derivative?—or that he didn’t understand their value as a hedging device. But he had always had a healthy fear of them, because he understood better than most that in a crisis, their combination of excessive leverage and counterparty exposure could make them an immensely destructive force.

  “I remember Bob at Goldman in the 1980s,” says a former colleague. “He was always the guy saying, ‘I’m not sure how much principal risk we should be taking with the derivatives book.’ When it got to be a $1 billion book, the traders wanted $2 billion. Bob would agree reluctantly. By the time Bob left, it was probably a $10 billion or $12 billion book. But Bob was always worried.”

  His fear stemmed from something almost no one else in government could claim: actual experience with a derivatives meltdown. It happened in the late 1980s when a sudden, unexpected shift in interest rates—unforeseen by Goldman’s risk models, needless to say—wreaked havoc on the bond and derivatives markets. “Bonds and derivative products began to move in unexpected ways relative to each other because traders hadn’t focused on how these securities might behave under the extremely unlikely market conditions that were now occurring,” Rubin writes in his memoir. “Neither Steve nor I was an expert in this area, so our confusion was not surprising. But the people who traded these instruments did not fully understand these developments, either, and that was unsettling. You’d come to work thinking, We’ve lost a lot of money but the worst is finally behind us. Now what do we do? And then a new problem would develop. We didn’t know how to stop the process.” He concludes: “What happened to us represents a seeming tendency in human nature not to give appropriate weight to what might occur under remote, but potentially very damaging, circumstances.”

  Once he got to Washington, Rubin found himself surrounded by people who viewed his lack of enthusiasm for derivatives as an amusing eccentricity. Most of the young turks he brought with him to Treasury were gung-ho about derivatives. His core group of young assistant secretaries—including a thirty-seven-year-old Treasury wunderkind named Timothy Geithner—approved of derivatives. Larry Summers used to tell Rubin that his attitude about derivatives was a little like a tennis player who wanted to keep using wooden rackets when everyone else had moved to graphite. And of course there was Greenspan, whose enthusiasm for derivatives knew no bounds. During the derivatives battles in the mid-1990s, dozens of officials from the Fed and Treasury—including Greenspan—testified in favor of unregulated derivatives and argued that the best thing the government could do was stay out of the way. Despite his qualms about derivatives, Rubin never once said anything publicly to contradict the Clinton administration party line.

  Oddly enough, it was the SEC that sent the first shot across the bow: in December 1997, it proposed that the investment banks it supervised put their derivatives businesses in a separate unit, and register them—voluntarily!—with the agency. Under this plan, derivatives dealers would have capital requirements (but they would be lower than the parent firm’s!) and they would have to use risk models to calculate the riskiness of their derivatives book (but they could use their own internal VaR!). In fact, the derivatives transactions themselves wouldn’t even be regulated by the SEC. The plan was called “Broker-Dealer Lite.”

  When the SEC put its plan out for public comment, Greenberger quickly drafted the CFTC’s response. Writing that the SEC proposal raised serious “jurisdiction” issues, the CFTC argued that if any agency should by rights be overseeing derivatives it should be the CFTC. Born would later say that she didn’t care who wound up regulating derivatives, so long as it was done right. The SEC’s “lite” approach hardly qualified. She then instructed Greenberger to draft a policy paper. The draft he came up with, thirty-three pages long, was called a concept release; it asked market participants and others a series of open-ended questions aimed at “reexamining” the agency’s approach to derivatives. Should players in the swa
p markets be required to report their positions to the government? Should swaps be sold through a central clearing facility? Should the CFTC impose capital requirements on derivatives transactions? Should derivatives dealers be made to conform to certain internal control standards? And so on.

  The draft of the concept release was completed in March 1998. As an independent regulator, Born had the right to simply publish it and let the world react. But she didn’t do that. Viewing herself as someone who wanted to collaborate with other regulators, she sent it around to all the other important actors—not just the other regulators, but lobbyists, key legislators, and the Treasury Department—to solicit their feedback.

  Feedback? Blowback was more like it. “One day I walked into Brooksley’s office,” says Greenberger. “She put down the phone and all the blood was drained from her face. She said, ‘That was Larry Summers.’ He had been screaming at her.” Summers had told her that he had just been visited by a group of bankers who said that if the CFTC insisted on pursuing their concept release, they would move their derivatives business to London. “Summers wanted us to stop,” says Greenberger. Adds Born: “There was so much pressure. The derivative dealers did not want this market looked at—at all. For some of them, derivative trading made up 40 percent of their profits.”

  A month later, the President’s Working Group met to discuss Born’s concept release. The PWG, as it’s called, consists of four regulators: the chairs of the Fed, the SEC, and the CFTC, plus the Treasury secretary. But this had become such a hot-button issue in Washington that virtually all the bank regulators were there: Larry Summers. John Hawke, the comptroller of the currency. Ellen Seidman, the director of the Office of Thrift Supervision. William McDonough, the president of the New York Fed. “It was a very tense meeting,” recalls one person who was there. The date was April 21, 1998.

  The purpose of the meeting, it quickly became clear, was to persuade Born to back off. The other regulators made all the old arguments about the dangers of classifying derivatives as futures. Born, for her part, said that CFTC was a long way from trying to regulate derivatives; all it was trying to do was ask some useful questions and glean some useful answers. “Greenspan thought even asking the questions was dangerous,” recalls Born.

  And where was Rubin? Given his history of concerns about derivatives, you might have expected him to be Born’s one ally in the room. During the Asian financial crisis, Rubin had asked one of his aides to find out how much derivatives exposure U.S. financial institutions had to South Korea. “We couldn’t find out,” this aide recalled. Rubin was stunned. But in this meeting, Rubin sided, without hesitation, with his fellow regulators. His reaction to Born’s arguments was almost visceral—a far cry from the man who was so admired for his ability to listen and ask questions. He bullied Born in a way that seemed out of character to anyone used to watching him manage a meeting. “It was controlled anger,” Greenberger later recalled for the New York Times. “I’ve never seen him like that before or after.”

  Late in the meeting, Rubin turned to Born and said brusquely, “My general counsel says you have no jurisdiction.”

  “Our view is that we have exclusive jurisdiction,” she replied.

  Rubin: “Would you agree to discuss this with our general counsel before you issue the concept release?”

  Born: “Of course.”

  One suspects that Rubin thought this exchange would cause the issue to go away. Instead, it gave Born hope. She was a big-time lawyer after all; a frank and fruitful exchange of views with the general counsel of the U.S. Treasury was a fine outcome. It played to her strengths. Except that for the next two weeks she couldn’t get Treasury’s lawyer on the phone. That’s when her steely side emerged. In Born’s view, if the general counsel couldn’t be bothered to explain Treasury’s legal reasoning, then she saw no reason to delay the publication of the concept release. On May 7, the CFTC published it.

  The other three members of the PWG were incensed. Rubin, Greenspan, and Arthur Levitt, the chairman of the SEC, immediately sent a letter to Congress requesting that it block the CFTC’s effort to solicit comments. Rumors were spread that Born was just an impossible woman—too shrill and strident to work with the august members of the Committee to Save the World.

  Over the next few months, Born testified more than fifteen times in a series of highly charged congressional hearings about the concept release. It was an extraordinary spectacle: in one hearing after another, an array of Clinton regulators lined up to publicly denounce the action of another Clinton regulator. Congressional Republicans were only too happy to pile on.

  In a hearing before the Senate banking committee in July, for instance, Greenspan made the specious claim that derivatives were already adequately supervised: “I would say that the comptroller and ourselves for the banks and the SEC for other organizations create a degree of supervision and regulation which, in my judgment, is properly balanced and appropriate.”

  Jim Leach, the committee chairman, then addressed John Hawke, repeating Born’s complaint in her testimony that the proposed legislation “would delegate review of federal law governing derivatives markets from the jurisdiction of the CFTC and SEC to a body dominated by banking regulators with no expertise in derivatives and market regulation.” Leach continued, “I would like to ask Mr. Hawke—The name of the Treasury secretary of the United States at this time is Robert Rubin. Does he have a background in financial supervision and financial market participation?”

  “If he were here, he would say he spent twenty-seven years in that,” replied Hawke.

  Leach: “I would continue to ask Mr. Hawke—The name of the chairman of the Federal Reserve Board of the United States is Alan Greenspan. Does he have a background in financial market participation?”

  Hawke: “I believe he does.”

  More than a decade later, you can still hear them chuckling at that exchange.

  The concept release got nowhere. Persuaded by Greenspan et al., Congress slipped a provision into an agriculture bill that prevented the CFTC from acting on derivatives for six months—which just happened to be the amount of time left in Born’s term as chairman.

  Three months later, Long-Term Capital Management blew up.

  It would be hard to overstate the feeling of terror the LTCM collapse inflicted on Wall Street. The Russian crisis was taking place at virtually the same time; indeed, it was the precipitating event that had led to LTCM’s problems. The markets were incredibly volatile. The Dow Jones Industrial Average dropped 512 points one day in late August—the fourth largest drop in history—only to gain nearly 400 points one day in early September. The fear that the financial crisis, having swept through Asia and Russia, was about to hit the United States was palpable.

  The main reason it didn’t was that the New York Fed ordered all the big Wall Street firms into a room and insisted that they hammer out a rescue plan. In the end, fourteen firms injected equity into LTCM, effectively taking it over. (Only Bear Stearns refused to participate.) In other words, it was government action—not market discipline—that prevented disaster.

  Washington was every bit as terrified as Wall Street—as it should have been. The potentially destructive power of derivatives had been exposed. For that matter, all the tools of modern finance—excessive leverage, probabilistic risk models, unseen counterparty exposure—had been shown to be flawed. When Wall Street finally got a look at Long-Term Capital’s books, for example, it was astounded by the size of the firm’s total counterparty exposure: $129 billion. Up until that moment, LTCM’s lenders had only known about their own small piece of it.

  During a hearing on October 1, 1998, even the Republicans on the Senate banking committee fretted about whether the LTCM disaster signaled the beginning of another S&L-style crisis. If ever there was a moment when Bob Rubin could have used his immense stature to do something about the derivatives problem he had supposedly spent years worrying about, this was it. Even hard-line deregulators might have followed
his lead. But he did nothing of the sort. During that October hearing, Chairman Leach said to Born, “We owe you an apology.” One last time, Born pleaded with Congress to grapple with “the unknown risks that the over-the-counter derivatives market may pose to the U.S. economy.” Even after LTCM, she remained the only administration official willing to talk about the need for government oversight over the derivatives business.

  Six months later, the President’s Working Group issued a report on LTCM, which focused much more on the firm’s excessive leverage than its derivatives book, and which made exactly one regulatory recommendation: unregistered derivatives dealers should be required to report their financial risk profiles on some kind of regular basis. In a footnote, Greenspan dissented even from that recommendation.

  Although Brooksley Born signed her name to that report, she was unhappy with it, feeling that it only reinforced the government’s laissez-faire attitude toward derivatives. When the White House called and asked if she wanted a second term, she declined. By June 1999, she had returned to Arnold & Porter, where she resumed her practice until she retired in 2003.

  A few weeks after Born left the government, so did Rubin. Rubin never spoke to Born again after that April 1998 meeting. Immediately after the Long-Term Capital Management fiasco, she had reached out to Gary Gensler, then a high-ranking official at Treasury—later, ironically, the chairman of the CFTC—asking him to convey a message to Rubin. “We all seem to be on the same side now,” she told Gensler, hoping he would convey to Rubin that she wanted to work with him on the derivatives issue. Rubin never responded. Not long afterward, she attended a meeting at the Treasury Department in which she tried to congratulate Rubin for his role in containing the crisis. He brushed past her without saying a word.

  Years later, Rubin’s defenders would claim that it was Born’s hard-nosed approach that had turned him against her. She was too strident, they said, too legalistic, not deferential enough to the Treasury secretary. “If she had just been more collaborative,” said one such defender, “Rubin might have been her ally.”