Some of the most revered financial market gurus say they were blindsided by the rapid global market deterioration in early 2008. But there were some observers, including lawyers and law professors, who correctly predicted the meltdown and even called out warnings, but they were ignored. These individuals say the problem then and now can be described in a single word: derivatives.
At their core, derivatives are simply bets on what will happen in the future. In the past few decades, derivatives have evolved into complicated financial transactions such as interest rate and credit default swaps. In the era of the housing market boom, credit default swaps focused on mortgages and, more specifically, subprime mortgages.
Some observers say that as the derivatives market gained in popularity, some people forgot that these financial instruments, for all their fancy clothes, were still, when naked, risky bets. And even the most sophisticated trader appeared to have had little idea of the worth of these transactions, or their potential impact if the housing market crashed.
“It was like a tsunami. You’re standing out on the beach looking at a beautiful sunset, and all of a sudden you’re dead,” says Philip McBride Johnson, a derivatives lawyer at Skadden, Arps, Slate, Meagher & Flom LLP and past chair of the U.S. Commodity Futures Trading Commission (CFTC). “There was some queasiness within some people, but nobody really knew how big the problem would be.”
Because there was little, if any, oversight of the off-exchange derivatives market, regulators and economists had little idea how active the market had become, some experts say. In addition, financial institutions were not required to have a minimum amount of collateral to get involved in risky transactions.
If the off-exchange or over the counter (OTC) derivatives market is allowed to continue to operate in the dark and without enough rules, another global economic crisis is inevitable, these same experts say.
“It hasn’t changed—people who are selling [these products] don’t understand them, and the people who are buying them don’t understand them,” says Michael Greenberger, a professor at the University of Maryland School of Law and former director of CTFC’s Division of Trading and Markets. “The market needs to be regulated.”
Congress is working on legislation to provide oversight for and regulate the derivatives market. In December, the U.S. House of Representatives passed the Wall Street Reform and Consumer Protection Act of 2009, but the Senate still was wrangling over its version as this issue of Washington Lawyer went to press. The battling—both behind the scenes and in public—makes the effort appear in jeopardy.
Certainly, some economic policy experts and derivatives lawyers argue against a drastic change in regulation and oversight. Derivatives in various forms have been around for centuries. More recently, they say, innovative trailblazers have created complex derivative transactions. These transactions have become an increasingly important part of modern economic strategy. The marketplace, they add, should not be stifled by overregulation.
“The subprime crisis is a story not about derivatives, but about residential mortgage-backed securities,” says Gordon F. Peery, a partner specializing in derivatives at K&L Gates LLP in Boston. “Without the massive losses stemming from subprime securitization, people today would be going about their merry way closing derivatives deals for legitimate purposes without the specter of overregulation.”
However, some observers of the OTC derivatives market, such as former CFTC chair Brooksley E. Born, have been calling for oversight and regulation of the market for a decade.
“It’s hard for people to learn from experience,” says Born, a retired partner at Arnold & Porter LLP. “Somehow or other, there is still a widespread belief that the market is self-regulating even though we now have the most vivid example that that is utterly untrue.”
A Derivatives Primer
Derivatives are financial instruments that transfer the risk of a particular asset from one investor to another. Derivatives generally take the form of contracts, under which the parties agree to payments between them based upon the value of the underlying asset at a particular point in time. Derivatives contracts can be whittled down to two concepts: forwards and options.
A forward-based derivative obligates one party to buy and the other to sell an asset in the future for an agreed-upon price. Option-based derivatives often involve a contract allowing the buyer or holder the right, but not the obligation, to buy or sell an asset in the future at an agreed-upon price. In return, the buyer or holder pays a premium.
Versions of derivatives trading can be traced to clay tablets from Mesopotamia dating to 1750 B.C., according to Gillian Tett in her book Fool’s Gold: How the Bold Dream of a Small Tribe at J. P. Morgan Was Corrupted by Wall Street Greed and Unleashed a Catastrophe. In the 12th and 13th centuries, English monasteries made futures deals with foreign merchants to sell wool as much as 20 years in advance. In 17th-century Holland, merchants bought and sold tulip futures.
In this country, the modern era of derivatives trading began with the birth of the Chicago Board of Trade in 1848, creating a way to buy and sell futures and options on agricultural commodities. Wheat farmers, for example, could buy futures on the price of their wheat before harvest, and thereby hedge against low prices during a bumper crop.
These days, derivatives can be traded on an exchange or privately negotiated.
Agent of Good or Evil
Lynn A. Stout, the Paul Hastings Professor of Corporate and Securities Law at the University of California, Los Angeles, School of Law, is another economic policy observer who, like Born, has been arguing for increased regulation of derivatives for years and years.
Stout emphasizes that the common law has for centuries encouraged futures contracts when parties, such as wheat farmers, have an interest in the underlying asset. But, she says, the law traditionally has discouraged futures contracts where neither party actually has an interest. Stout describes these speculative contracts as essentially an unenforceable form of gambling. In an article written more than a decade ago, Stout warned that encouraging speculative derivatives contracts would be a substantial change in the law.
In 1884 the U.S. Supreme Court found a contract, betting on whether goods would be delivered in the future, unenforceable on the grounds of public policy. The Court said:
[I]f, under guise of such a contract, the real intent be merely to speculate in the rise or fall of prices, and the goods are not to be delivered, but one party is to pay to the other the difference between the contract price and the market price of the goods at the date fixed for executing the contract, then the whole transaction constitutes nothing more than a wager, and is null and void.
Stout asserts that common law dissuades our society from devoting “public resources to enforce these contracts that have no social benefit and only social harm.” Had economists watching the mushrooming derivatives market understood and respected common law precedent as lawyers do, Stout says they would have sounded the alarm.
But other economic policy experts and specialists dispute the notion that derivatives have no social benefit. These experts point out that numerous laws support the development of a thriving economic system by, in part, encouraging ways for institutions and companies to cover their losses. Derivatives, they say, are important and exciting tools for sophisticated investors to disburse the risks inherent in our economic system.
“The vast majority of derivatives have been functioning perfectly for years and years and many, like interest rate swaps, are as necessary as air and water to the way companies operate,” Peery says.
Era of Innovation
The modern-day derivative did not sprout into existence overnight. The 1970s brought disco, President Jimmy Carter, and innovation in derivatives.
In 1974 Congress created the CFTC as an agency with the mandate to regulate the futures and options markets. But in the late 1970s, unpredictable swings in exchange rates and oil prices brought on a new wave of invention. Investors, looking for ways to protect themselves from high interest rates and erratic exchange rates, turned to futures and options contracts. For example, an investor could bet on future interest rates or buy the right to future purchase of currencies at specific exchange rates.
Investment banks also began brokering swaps in which two parties exchanged obligations. In 1981, for example, IBM and the World Bank swapped their bond earnings and obligations to bondholders.
Derivatives used during the 1970s and 1980s provided two functions, economic policy experts say. For some, it was important to control risk by getting another party to lock into a particular price or obligation. For other parties, such as investors, derivatives were high-risk bets with the chance of a huge windfall.
The question for Congress and economic policy advisers and experts has been whether the CFTC or any other agency has or should have jurisdiction over derivatives. In 1992 Congress gave the CFTC the power to exempt from exchange trading particular derivatives if it could be proven that it was in the public interest to do so. Not long after, the CFTC exempted individually customized swaps.
“At first, Wall Street thought they had gained a great victory,” Greenberger says. “It soon turned hollow because they realized that creating individualized transactions interfered with cookie-cutter, profitable, standardized deal making.”
And then came what some observers call a monumental innovation. In 1994 a team working for JPMorgan Chase & Co. designed a swap that shifted the risk of credit default to a third party. The third party agreed to cover any loss on the face amount of a bond or loan. The party buying the insurance paid an upfront amount and yearly premiums.
Within a few years, these credit default swaps became favorites of investors who were betting whether particular companies would have financial problems. However, as the market continued, the swaps were changed, rebundled, and resold, until, some observers say, it was unclear to even the buyers and sellers the worth of the underlying assets.
“The beauty and the danger of derivatives is that you can create almost anything, and the degree of complexity that is available is almost limitless,” says Robert A. Wittie, a partner specializing in securities finance and investment management at K&L Gates. “Used properly, that can be terrific. But it can become very opaque. It can be hard for investors to understand the assets they are buying.”
In retrospect, some observers say, there were plenty of warning signs that certain derivative transactions were too risky for the market to bear.
In December 1994, prosperous Orange County, California, was forced to declare bankruptcy after suffering losses of about $1.6 billion from failed futures bets on interest rates. Orange County and other local entities had pooled their money in an investment strategy. The county had relied upon its longtime and well-regarded treasurer, Robert Citron, for investment strategies. Citron invested the funds in a leveraged portfolio of mostly interest-sensitive derivatives contracts.
Citron’s strategy depended on short-term interest rates remaining relatively low, but the Federal Reserve Board began to raise U.S. interest rates, and Orange County’s investment pool plummeted in value. Orange County’s subsequent bankruptcy filing was the largest municipal bankruptcy in U.S. history.
And then came the Barings Bank disaster in 1995. London-based Barings Bank had a rich history, including helping finance the Louisiana Purchase, but it collapsed in large part due to some risky derivatives transactions. In the early 1990s, Nick Leeson, an ambitious derivatives trader in Singapore, made seemingly small gambles in the futures arbitrage market and hid his shortfalls by reporting losses as gains.
In January 1995, when an earthquake hit Kobe, Japan, the Asian financial markets began to collapse. Leeson wagered that the Nikkei would recover quickly, which it didn’t. Ultimately, he cost Barings more than a billion U.S. dollars, leading to its insolvency and purchase by the ING Group, according to numerous news accounts.
Also in the mid-1990s, Procter & Gamble Co. and several other companies sued Bankers Trust Company for misleading them on the level of risk and value of derivatives they had purchased from the bank. Procter & Gamble was permitted to add to its lawsuit allegations involving the Racketeer Influenced and Corrupt Organizations Act. The lawsuit settled in 1996. However, the bank first had to reveal tapes in which its employees were heard talking about derivatives as a “massive, huge future gravy train” and a “wet dream.”
Another tale of derivatives-trading-gone-wrong came in 1998 and involved popular hedge fund Long-Term Capital Management.
Long-Term Capital’s trading strategy concentrated on fixed income arbitrage deals, combined with high leverage, and a variety of other derivatives investments. Eventually, the hedge fund faced $4.6 billion in total losses. To avoid systemic losses in the financial system, the Federal Reserve Bank of New York arranged for a more than $3.6 billion rescue package from leading investment and commercial banks.
In the aftermath of these large-scale investment failures, some economic policy experts called for increased regulation of derivatives. But, for the most part, derivatives trading continued to develop free of regulatory bindings. Some economic policy analysts say the reluctance to regulate the derivatives market stemmed from the prevailing economic theory associated with the University of Chicago’s Department of Economics.
“The free market ideology trumped everything else,” Stout says.
The Battle of 2000
In August 1996, Born, an experienced Washington lawyer, was sworn in as chair of the CFTC. It didn’t take her long to conclude that unregulated derivatives were a danger to the country’s financial stability.
“I thought it was very dangerous to have a market that big that no regulator had information about,” Born says.
Under Born’s authority, the CFTC put out a concept release asking for feedback on the nature of the derivatives market, questioning what should be done to change the regulatory setting.
Born met with resistance from high-ranking officials, including then-Federal Reserve Board chair Alan Greenspan, former U.S. Securities and Exchange Commission chair Arthur Levitt, former Treasury Secretary Robert E. Rubin, and Rubin’s then top deputy, Lawrence Summers, who is now director of the White House National Economic Council.
Greenspan, Levitt, and Rubin issued a joint statement saying, “We seriously question the scope of the CFTC’s jurisdiction in this area,” and expressing “grave concerns about this action and its possible consequences.” They also announced a plan to pursue legislation to “provide greater certainty” for the legal status of OTC derivatives.
Born recently has received a fair amount of attention for her foresight, and has even been described by some of her supporters as a modern-day Cassandra. However, Born was not the only person alarmed by the unregulated development of derivatives. In fact, there was a vocal minority of economic policy experts questioning how the derivatives market was being handled at that time.
“I don’t think Brooksley ever claimed to have been Joan of Arc, and I don’t think she was Joan of Arc,” says Mark D. Young, a partner at Kirkland & Ellis LLP and former assistant general counsel for the CFTC. “But she—and the people around her—were asking good questions.”
“She had a political problem, and she also had a legal problem,” Young continues. The legal problem, as Young explains it, was that if she were right, and the CFTC had jurisdiction over OTC derivatives, there were already a number of equity swaps that would have been defined as futures, and therefore voidable.
“If these swaps had been voidable, it would have created a crisis,” Young says. “It was a real concern, the unspoken unspeakable, but it was there.”
Before the end of Born’s term at the CFTC, Congress put a six-month hold on the agency’s ability to use regulatory power over OTC derivatives.
In 2000 Congress enacted the Commodity Futures Modernization Act (CFMA), which limited the CFTC’s ability to regulate OTC derivatives. But the act clarified that the majority of OTC derivatives transactions between “sophisticated” parties would not be regulated as either securities or futures. Instead, federal regulators supervised banks and securities firms involved in these transactions as part of ensuring “safety and soundness” standards.
“When Congress legalized speculative derivatives trading in 2000, it unintentionally added massive risk to the financial system on an unprecedented scale,” Stout says. “It’s as if Congress made murder legal for the first time and called the statute the Homicide Modernization Act. I don’t think it understood what it was doing.”
And then, only a year later, Enron Corporation filed for bankruptcy in an accounting scandal that included the extensive use of derivatives and special purpose entities.
As virtually everyone knows now, the seeds of the economic crisis can be found in the housing boom and low interest rates in the early 2000s. As housing prices rose, mortgage companies relaxed their lending criteria and began selling mortgages to first-time, low-income homebuyers. Subprime loans were aimed at borrowers with poor credit, and generally carried higher interest rates than more conventional loans. But the subprime market also helped a political goal—putting low-income and minority families into their own homes. Between 2004 and 2006, Freddie Mac and Fannie Mae, government-chartered mortgage finance firms, purchased $434 billion in securities backed by subprime loans.
Mortgage companies sold collateralized mortgage debt to other banks and financial institutions as a kind of insurance. The swaps could then be rebundled and sold again in a series of complex financial transactions.
“The whole concept of the subprime situation was the lending institutions did not want to hold on to the risk,” Greenberger says. “The mortgages got packaged. The bet became that these borrowers—people who were risks, whose credit often was never checked—would pay nevertheless.”
Despite or perhaps because of the risk inherent in these transactions, the mortgages were morphed into credit default swaps and mortgage-backed securities, and traded hands often.
“When you tell someone that they can sell a hand grenade with the pin out, but they don’t need to worry about it because someone else will own it when it goes off,” Johnson says, “you get a lot more hand grenades with the pin out being sold.”
Meanwhile, rating agencies gave these debt bundles AAA safety ratings, inducing even the most sophisticated investors into viewing these particular financial instruments as a great way to get a high return without too much risk.
“People were hungering for the collateralized debt obligations because they believed the housing market would continue to go up,” Greenberger says. “Housing prices would always go up—that was the driving algorism.”
The market size for credit default swaps increased rapidly—by 2007 the market had a notional value of $45 trillion, about twice the size of the U.S. stock market.
“What was happening was that without people really realizing it, lenders as a whole were putting a huge amount of risk on their books,” Wittie says. “All of this works great in theory, but ultimately what you’ve got is a bunch of borrowers who are either going to pay off the loan or not. No amount of complexity can change that, but the amount of complexity can mask it for a while.”
Then came the crash. Many of the riskier homebuyers had bought adjustable rate mortgages that became unaffordable for them when interest rates increased. Suddenly, banks that had large portfolios of credit default swaps found themselves facing enormous losses and unable to find other institutions to provide credit to help them cover the cost of repayment.
Lehman Brothers Holdings Inc. was the first of the large institutions to self-destruct. In the first half of 2008, Lehman’s stock lost 73 percent of its value as the credit market continued to tighten. On September 15, 2008, Lehman filed for Chapter 11 protection, the largest bankruptcy filing in U.S. history. That day, Lehman’s shares tumbled, and the Dow Jones closed down just over 500 points, the largest drop in a single day since the aftermath of the September 11 attacks.
At the same time, insurer American International Group Inc. (AIG) also was unable to drum up the collateral to cover its massive losses. However, with AIG’s collapse came government rescue and recognition that the country was in a rapid downward slide.
“Everything truly blew up in an undeniable way when Lehman blew up,” Wittie says.
The Blame Game
Some economic policy experts lay the blame for the Great Recession on Congress’ failure to impose regulation and oversight on the derivatives market.
Financial leaders and government officials should have listened to Born’s warning in the late 1990s, these experts say. At the very least, they should have listened when legendary investor Warren Buffet called the rapidly growing derivatives market “financial weapons of mass destruction” in 2003.
Greenspan has since admitted that the 2008 financial crisis exposed a “flaw” in his ideology. During congressional testimony in 2008, Greenspan said he’d been “partially” wrong and that credit default swaps “have serious problems associated with them.” However, he emphasized that, excluding credit default swaps, the “derivatives markets are working well.”
Greenspan, now president of the Washington-based consulting firm Greenspan Associates, LLC, did not respond to an interview request.
While some observers blame the crisis squarely on OTC derivatives, or more specifically on credit default swaps, others argue that unregulated OTC derivatives cannot take all the blame for the financial meltdown.
“Generally speaking, derivatives have been overly vilified as a key cause of the financial market meltdown,” says Kenneth M. Raisler, former general counsel for the CFTC and now a partner in the New York office of Sullivan & Cromwell LLP. “They were a contributor, as were all sorts of financial transactions. Derivatives were just a vehicle that some people were using for irresponsible risk-taking. They were not the evil per se; they were vessels for some mismanagement and bad risk-taking.”
Other economic policy experts say that had credit rating agencies not held so much sway, investors would have been a little more wary of swaps they did not completely understand.
“The odd thing about this crisis is that regulators and investors weren’t paying attention to the mortgage or the credit default markets,” says Frank Partnoy, the George E. Barrett Professor of Law and Finance at the University of San Diego School of Law. “They kept focusing on the credit rating agencies who said everything was fine.”
But Wittie says that while it’s human nature to want to find a bad guy to blame, it may end up that the truth gets distorted in the process.
“People want to try to point the finger at somebody or some particular player and say, ‘Ah, they did it,’” Wittie says. “Not only are they likely to be wrong, but it implies a level of negligence or malfeasance that isn’t necessarily there.”
All About Regulation
This year, as in years past, Congress is debating how to approach derivatives oversight and regulation. At first, White House Economic Adviser Paul Volcker proposed prohibiting financial firms from owning hedge funds or from proprietary trading on their accounts. Meanwhile, CFTC Chair Gary Gensler has argued extensively for increased regulation of derivatives, as has the White House. Gensler has estimated that the OTC derivatives market is worth $300 trillion.
The House of Representatives passed the Wall Street Reform and Consumer Protection Act in December 2009, but not without a struggle and some compromise. Lawmakers voted 223–202 to provide oversight and ensure transparency for derivatives transactions. The act would mandate that swaps move through CFTC-regulated clearing facilities. Under the proposed law, these clearinghouses would impose initial margin or collateral requirements. However, the bill has written into it exemptions for end users, or so-called “bona-fide hedgers” who use the futures markets to offset their operational risk.
Rep. Collin C. Peterson (D–Minn.), chair of the House Agriculture Committee, said on the floor that “exemptions to the clearing requirement should be available because not every swap is appropriate for clearing and not every market participant should have to bear the burdens of clearing.
“End users did not get a bailout of billions of dollars. End users are not responsible for what happened in the markets last year,” Peterson argued.
But Gensler has publicly criticized the House bill for its end-user exemptions. “Wall Street appears to be aligning [itself] with corporate end-users in an effort to exempt customer transactions from central clearing,” Gensler said in March. “While only approximately 9% of the market represents transactions between dealers and nonfinancial end-users, Wall Street seems to be making the case that financial end-users also should be exempt. This could possibly leave 60% of the clearable market outside of clearing.”
As of press time, two Senate committees, the Senate Banking Committee and the Senate Agricultural Committee, had approved financial reform bills to bring, in part, greater transparency to the derivatives market.
Senate lawmakers, also as of press time, were still quibbling over the scope of exemptions for end users.
The prolonged debate and compromise in Congress over how and when and whether to regulate derivatives frustrates those observers who think it is obvious that better oversight and stricter rules are needed.
“There should be regulation, there should be transparency, and there should be a robust system of regulation imposed, including exchange trading and clearing,” Born says. “We haven’t made much progress.”
A representative from the International Swaps and Derivatives Association, Inc. declined to comment for this story.
But Peery warns that a swing from free market system to strict regulation could stifle the ability of those on Wall Street to take even reasonable risks—a key to a thriving market.
“There are so many aspects of the OTC derivatives market that have been functioning properly for decades. That’s undisputable,” Peery says.
At any rate it’s unclear whether the current legislative attempts to regulate derivatives will progress or die with the end of the term.
“I think Congress will pass a bill, and it will, among other things, provide a regulatory regime for swap transactions and address counterparty credit risk and transparency,” Young says. “But at present, where are we? We’re Waiting for Godot.”
Freelance writer Anna Stolley Persky wrote about food safety in the February 2010 issue of Washington Lawyer.