During the 1992 presidential campaign, Levitt made campaign contributions in the six-figure range, ensuring that several candidates would consider him for an appointment. He gave money to a few unsuccessful presidential candidates, took various politicians on Outward Bound expeditions, and even made a small contribution to Pete Domenici, a Republican on the Senate Banking Committee. But his focus was on William Jefferson Clinton. When Clinton won the Democratic primary, Levitt helped raise $3.5 million for him, and made a personal gift of $40,000 to the Arkansas Democratic party.
When Clinton won the election, the only remaining question for Levitt was whether Clinton would be willing to give a senior appointment to a former stockbroker. During the previous twelve years, Republicans had been cautious about naming Wall Street executives to positions of power, fearing that the public would criticize them for having the fox guard the henhouse. Democrats historically had been even more reluctant to appoint financial executives.
But Bill Clinton had experienced an epiphany about Wall Street during the presidential election. Before 1992, experts had predicted that Clinton would be an unsympathetic president to Wall Street. But Clinton had learned about the power of the financial lobby when he suffered after criticizing Wall Street during the campaign. As president-elect, he famously said, “You mean to tell me that the success of the economic program and my reelection hinges on the Federal Reserve and a bunch of fucking bond traders?” When Clinton discovered that voters cared much more about whether the stock market was going up than other economic issues, he increased support for Wall Street—a then-current and potential future source of substantial campaign contributions—and committed to continue the deregulatory policies of the previous Republican administrations. Clinton appeased the populist anti-corporation forces by making a campaign pledge to halt the allegedly excessive pay of corporate executives.6
Levitt waited to receive a call about a Cabinet position. But there were too many potential nominees with more distinguished backgrounds, including Robert Rubin, who was a much bigger name than Levitt on Wall Street and had been co-chairman of Goldman Sachs, an even bigger campaign contributor. In April 1993, Clinton nominated Levitt to be chairman of the SEC.
Levitt was disappointed. Still, it was an important post and might be a stepping stone to the Cabinet, so Levitt took every measure to ensure the Senate’s approval. Numerous securities lawyers objected to Levitt, for numerous reasons, not the least of which was that Levitt didn’t have legal experience or even a law degree. (Only two previous SEC chairmen since the 1930s had been non-lawyers.) He tried to assuage their concerns, as he firmed up his Wall Street support, meeting with senior banking officials at the annual dinner for the new governors of the American Stock Exchange, and speaking at a conference held by a major securities lobbying group, the Securities Industry Association.7
Levitt also sold his majority stake in Roll Call—for an estimated $8 million to $10 million8—after officials suggested, quite sensibly, that Levitt couldn’t both negotiate with members of Congress and report on them. Levitt didn’t see the conflict of interest right away, but eventually agreed to sell the stake. There also were allegations that Levitt had possessed inside information when he bought Roll Call, but he denied them.9 (Ironically, conflict-of-interest issues—ranging from accountants offering consulting advice to securities analysts receiving compensation based on the banking business done with firms they covered—would play a prominent role during Levitt’s last years at the SEC.)
Levitt’s confirmation hearing before the Senate Banking, Housing and Urban Affairs Committee was set for July 13, 1993. Levitt’s testimony was perfectly engineered. He began by introducing his wife and children, who were there to show support. Levitt then told the senators what they wanted to hear. Republican senators Pete Domenici and Lauch Faircloth had recently held hearings on abusive securities lawsuits, and Levitt showed support, an odd position for a candidate to be the lead securities cop. He assured them, “I have experienced the pain and the cost of this litigation. I will work to see if we can come up with a solution.”10 Levitt also could point to his credentials as founder and chair of the American Business Conference, a group that supported laws curbing securities suits. The earlier gift to Senator Domenici probably didn’t hurt, either.
There were a few tense moments, especially when Levitt dodged questions about accounting for stock options. Companies were not required to record as an expense the cost of stock options they gave executives, and several prominent legislators were opposed to a recent proposal to add that requirement. Levitt said that, although “as a recipient of options, I know how important options are, nonetheless, I must share with you a nagging reservation about the process of passing legislation to set accounting rules.” He suggested a compromise position: more complete disclosure about options compensation as an alternative to requiring that companies include them as an expense.
When asked about derivatives, Levitt said he worried that companies might be playing with fire: “I am not persuaded that all managements of firms totally understand their impact.”11 Levitt later repeated his concern when Lou Dobbs, anchor of the Cable News Network television show Moneyline, asked him about derivatives, saying, “I think there is a lack of understanding in terms of how to use them and a lack of understanding in terms of the ways they can be used.”12
But apart from these questions, Levitt skated through the hearing. His confirmation was a yawn compared to that of Dr. Joycelyn Elders, the nominee for surgeon general, who had distributed condoms in Arkansas public-health clinics and schools. With the media focused on Elders, the Senate voted to approve Levitt; he quickly returned the favor, appointing Republicans to most of the key SEC positions: director of enforcement, general counsel, and even spokesman.13 No one even asked about Roll Call.
The first few months of Levitt’s term were quiet, and the Clinton administration was hands-off. Financial-market regulation was split between Levitt’s SEC (which had jurisdiction over “securities”) and the Commodity Futures Trading Commission (which had jurisdiction over “futures”). The two agencies had fought over turf for decades. In January 1993—just days before President Clinton took office—departing CFTC chair Wendy Gramm delivered her “farewell gift” to the derivatives industry, signing an order exempting most over-the-counter derivatives from federal regulation. (A few months later, she would receive her own farewell gift, being named a director of Enron, which was an active trader of natural gas and electricity derivatives.)
Levitt decided not to press the issue, even though it remained unclear whether many derivatives fit under SEC or CFTC jurisdiction. Wendy Gramm’s swap exemption was based on a 1992 law that allowed the CFTC to exclude from regulation any swaps that involved individually negotiated contracts among sophisticated parties. The CFTC’s swaps exemption had expanded to include virtually all swaps, including those that were standardized and involved less sophisticated parties. Nevertheless, no one in the Clinton administration opposed this expansion. The new CFTC chair, Sheila Bair, kept the exemption in place, saying, “We have a strong affinity for derivatives at this agency. We like them.”14 On October 28, 1993, Levitt appointed Howard Kramer to the newly created SEC post of associate director for derivatives, but the SEC didn’t propose any major initiatives related to new financial products.
Meanwhile, there were two major government studies of derivatives under way. In 1992, Congress had asked the General Accounting Office to consider whether derivatives regulation was necessary. Derivatives dealers were nervous about what the GAO and its director, Charles Bowsher, might say. At the same time, Representative Jim Leach of Iowa was probing the derivatives markets, asking some uncomfortable questions of Mark Brickell and the ISDA lobby; Leach’s staff on the House Banking Committee also began preparing a report.
As the leading Republican on the Banking Committee, Jim Leach was an unlikely critic. Why was Leach so different from his colleagues, who were uninterested in derivatives regulation?
Why was Leach alone in publicly warning that derivatives markets were out of control and might cause a system-wide collapse? The only discernible difference between Leach and other members of Congress was that Leach did not receive financial support from Wall Street and members of the ISDA. Because he refused to accept contributions from political action committees, Leach could speak with an independent mind. By contrast, Senator Alfonse D’Amato—Representative Leach’s counterpart for financial issues in the Senate—received $1.7 million in PAC money from the financial industry from 1987 to 1995.
Mark Brickell had lobbied Leach unsuccessfully, and when his efforts failed, he tried to isolate Leach from the rest of Congress. Brickell was reportedly furious when ISDA invited Leach to speak at a 1993 conference, and he began bad-mouthing him, questioning his motives, and saying that Leach and his staff didn’t know what they were doing.15
Under Leach’s direction, the House Banking Committee staff issued a 900-page report on financial derivatives in November 1993—more than three months before the Fed’s rate hike.16 The staff had met with all of the major federal regulatory bodies, several of the major banks, numerous lobbyists (including ISDA), and even the two largest credit-rating agencies, Standard & Poor’s and Moody’s. The report addressed every major issue confronting the markets for derivatives, which Leach called both “the new wild card in international finance” and a “house of cards.”
ISDA’s lobbyists tried to minimize the impact of Leach’s report. Joseph Bauman of ISDA told a Washington Post reporter, “I have a tough time conceiving of any event that would make derivatives the culprit of something that really crashed the system.”17 Derivatives were an abstract issue, and the public paid little attention. The GAO was still working on its report as the Fed raised interest rates in early 1994.
After the Fed’s rate hike, Wall Street’s lobbyists mobilized. They met with regulators and lawmakers immediately. ISDA held an “end-user” meeting to try to neutralize the companies and mutual funds that had lost money on derivatives. In April 1994, the group named Brickell—who already had served as chairman—to be vice chairman, so that he would remain involved. As the media reported on the various scandals, ISDA especially needed Brickell to assist with a public-relations nightmare. Brickell was skilled at deflecting criticism: for example, when Neil Cavuto, the CNBC television news anchor, began a May 25, 1994, interview by telling Brickell, “People don’t like you guys for some reason,” Brickell responded by saying, “Well, our clients do.”
Fortunately for ISDA, Jim Leach became distracted during early 1994 by an investigation into President Clinton’s involvement in the Whitewater scandal in Arkansas. This investigation was a political priority and temporarily shifted Leach’s attention away from derivatives.
During this time, Arthur Levitt was involved only at the periphery. Instead, Treasury Secretary Lloyd Bentsen led the administration’s response. He reassembled the president’s Working Group on Financial Markets—a group of financial officials who had analyzed the causes of the 1987 market crash—to consider the 1994 losses. Levitt was a member, but the Working Group did little substantive work, and instead actually served to ease ISDA’s task by concentrating the lobbyist’s efforts on a smaller number of designated officials. In one day, senior bankers could make all of the required rounds in Washington. Consider March 15 as one example. Officials from one firm (in this case, Morgan Stanley) met with senior Treasury officials, the chief economist and several lawyers from the Senate Banking Committee, several House of Representatives legislative directors, a lawyer with the House Banking Committee, and the staff director of the House Small Business Committee, all in one day.
Arthur Levitt gave a few speeches warning investors about derivatives during the months following the rate hike. In March 1994, he called for mutual-fund directors to pay more attention to their investments in derivatives: “With millions of inexperienced investors leaving the safety of bank CDs for the expectation of higher returns in the mutual fund market, we can ill afford even the perception of conflict.”18 In April, he told Congress that until they learned more about derivatives, “we’re shooting in the dark in terms of the amount of risk involved.” But Levitt made few substantive proposals.
In contrast, Richard C. Breeden, the former SEC chairman who oversaw the deregulation of the early 1990s, during the first Bush administration, immediately began warning corporate directors and officers about the dangers of derivatives. He wrote an opinion piece in the Wall Street Journal on March 7, entitled “Directors: Control Your Derivatives,” in which he scolded corporate managers using derivatives and warned that they needed to shape up or face a “one-way ticket to financial disaster.” Breeden also questioned whether companies that said they used derivatives to hedge really were speculating.19 Even as a former SEC chair, Breeden was exerting more influence over the markets than Levitt.
In May, Arthur Levitt admitted to a group of 1,500 mutual-fund executives that the SEC didn’t have the resources to police the mutual-fund industry, and he instead blamed the funds for the losses, saying, “In the final analysis, compliance is the principal responsibility, not of the commission, but of each investment company.” Instead of adopting new rules, the SEC sent the funds a letter advising them to sell certain types of structured notes, including inverse floaters. The SEC’s list of “dangerous” structured notes included many instruments investors had never heard of; Antony Michels of Fortune magazine advised, “Don’t bother asking what these things are, but if a fund owns them, don’t buy it.”20 Levitt tried to suggest to the public that the mutual-fund losses—which involved so many major funds—were isolated, even though the deluge of media coverage of fund losses indicated otherwise. He naively told Congress, “Our inspections to date suggest that the use of derivatives by most funds is limited.”21
Also in May, the GAO finally released its two-year, 195-page study of derivatives.22 The GAO was a strong supporter of free markets, but it found many serious problems related to derivatives, including regulatory gaps, antiquated accounting practices, and uncontrolled risk-management. It recommended a sweeping overhaul of derivatives regulation, including “federal regulation of the safety and soundness of all major OTC derivatives dealers.”
Levitt opposed the GAO’s recommendations, as did most federal regulators, who distanced themselves from GAO leader Charles Bowsher. ISDA immediately issued a point-by-point attack of the report, saying that although some of the facts in the report were correct, the GAO’s conclusions were flawed. For example, ISDA noted that requiring companies to mark to market their derivatives would introduce “artificial volatility into the financial statements of commercial and industrial companies.”23 ISDA also argued that the actual amount of money at risk in derivatives was only two percent of their stated (or notional) value. In other words, it was misleading to talk about $50 trillion of derivatives when a mere $1 trillion was at risk.
The GAO seemed to have the better argument. Mark-to-market procedures had been the sources of trouble at financial institutions since the days of Andy Krieger at Bankers Trust. The problem with companies keeping derivatives on their books at historical cost was that, as valuations changed, investors had no idea of the changes. ISDA was correct that marking to market would make corporate earnings more volatile, but that was because corporate earnings were more volatile. Hiding the fluctuations didn’t make a company any safer. ISDA’s argument that only a fraction of the face value of derivatives was at risk also was correct. In fact, only a fraction of any investment—in derivatives or in stocks, bonds, or even real estate—was typically at risk at any point. But that didn’t mean the investment was safe, or that the markets were small. Moreover, ISDA’s two-percent number had ballooned after the Fed’s rate hike, reflecting the losses from the rate hike. By March 1995, the percentage would be closer to four, or almost $2 trillion—arguably, more money than was at risk at any point in the entire U.S. bond market.24
Nevertheless, investors were too diffu
se and poorly organized to counter ISDA’s arguments. Economists and political scientists had long predicted that small, well-organized groups (such as ISDA) would prevent diffuse and poorly organized groups (such as investors) from achieving legislative reforms in their best interests.25 Whatever the merits of the debate, investors never had a chance.
As one show of ISDA’s power, some of its lobbyists even persuaded journalists to stop using the word “derivatives,” which now had a negative connotation among the investing public. ISDA monitored the media carefully, and distributed press clippings on derivatives to all of its members. When ISDA’s watchdogs found that Wall Street Journal reporters were continually using the “d-word” in covering the various derivatives scandals of 1994, they implored them to say “securities” instead.
For example, Wall Street Journal reporters originally had referred to Orange County’s structured notes as “derivatives,” but stopped doing so at ISDA’s suggestion. An ISDA director noted in a letter to Byron E. Calame, deputy managing editor of the Journal, that the “problem” had been corrected, and “that in your report about promising developments in Orange County’s situation, the reporter never once used the word derivatives, referring to them only as securities.” When another reporter referred to complex instruments linked to the Mexican peso as “derivatives,” ISDA admonished Calame, “Because we read your newspaper and know that a lot of people rely on it to increase their understanding of financial activity, we think it’s important that financial activities are accurately and consistently reported.”
The “d-word” began appearing much less frequently, especially in the Wall Street Journal. This was true even though the groups within banks that sold the financial instruments at issue—including those related to Orange County and the Mexican peso—actually called themselves “derivatives” groups and referred to the financial instruments as “derivatives.” But investors didn’t like that word, and ISDA wanted it expunged from the public record. (Ironically, ISDA had just added the word “derivative” to its own title, when it changed its name in 1993 from the International Swap Dealers Association to the International Swaps and Derivatives Association, in an attempt to show ISDA was more than just a lobbying vehicle for the top swap dealers.)26
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