This is part 1 and 2 of a work in progress which I hope will be a series of posts on the legislative history of the decisions taken to deregulate our financial markets and which have contributed to the current economic crisis. For the details and reference links behind these summary posts, organized as a timeline, see my Financial Regulation Timeline page (where these summaries are x-posted).

Introduction:

It has become conventional wisdom among Democrats that Republicans (epitomized by Phil Gramm, past chair of the Senate Banking committee) were responsible for pushing deregulation that "set the stage for the financial meltdown." But what about the Democrats? Have their policies been supportive of the regulation that would have prevented what has been called the greatest financial crisis since the Great Depression? Answering this question has become more important as Obama puts together an economic team that includes names from the era of deregulation.

Looking back through the legislative and administration record since the early ’90s, what emerges is not primarily a partisan battle of Democrats vs Republicans, although that was part of it. The battle was one of the majority of Congress (usually under Republican control) allied during the Clinton administration with Treasury (Rubin and then Summers), the Fed (Greenspan) and the SEC (Levitt, who now says he regrets his role) against a few people in Congress (Markey) and the CFTC (Born and Greenberger) who thought that over-the-counter (OTC) derivatives should not be left entirely unregulated.

Other regulatory issues, for example, the repeal of Glass-Steagall, exceptions from the Investment Company Act of 1940, exclusion from the Commodity Exchange Act (CEA) for some electronic trading systems for financial products contracts (aka, "the Enron loophole"), the use of Structured investment vehicles (SIVs) by mortgage lenders for off-balance-sheet accounting, changes by the SEC to release investment banks from the "net capital rule," credit rating agencies that are paid by the companies they rate instead of investors and the practice of using marking to model as a means of "marking to myth") when no liquid market exists for accurate marking to market have also been reported as contributing factors, but the complete lack of regulation for OTC derivatives such as credit default swaps (CDSs) is one of the most important and at this time, probably the most dangerous. So, the series will begin with OTC derivatives, to be followed by other issues as time and interest permit.

OTC Derivatives:

In 1992, H.R.707, the Futures Trading Practices Act of 1992 was signed into law. This bill "granted the Commission the authority to exempt over-the-counter (OTC) derivative and other transactions for CFTC regulation." Also in 1992, Congressmember Ed Markey, as chair of the House Subcommittee on Telecommunications and Finance, asked the General Accounting Office (GAO) to report on the potential risk due to the growing use of derivatives. The report was released 2 years later in May of 1994 and warned that the "the sudden failure or abrupt withdrawal from trading of any of these large dealers could cause liquidity problems in the markets and could also pose risks to the others, including federally insured banks and the financial system as a whole." This set off a flurry of hearings and in July Markey introduced H.R.4745, the "Derivatives Dealers Act of 1994," to legislate some regulation for OTC derivatives (under the jurisdiction of the SEC). However the bill only had one co-sponsor (Mike Synar) and never made it out of committee.

In January of 1993, just 2 days after Bill Clinton’s inauguration and on Wendy Gramm’s last day as chair, the Commodity Futures Trading Commission (CFTC) exempted "certain swap agreements and hybrid instruments from regulation under the Commodity Exchange Act."

In May of 1998, the CFTC proposed "reexamining its approach to the over-the-counter (OTC) derivatives market" and sought public comment. In particular, Brooksley Born, chair of the CFTC, "was concerned that unfettered, opaque trading could “threaten our regulated markets or, indeed, our economy without any federal agency knowing about it,”… She called for greater disclosure of trades and reserves to cushion against losses." However, senior members of the Clinton administration pressured her to back off and when she did not, Greenspan, Rubin and Levitt asked Congress to act to prevent the CFTC from regulating OTC derivatives. Congress responded with a 6 month restraint period, during which the CFTC "may not propose or issue any rule or regulation, or issue any interpretation or policy statement, that restricts or regulates activity in a qualifying hybrid instrument or swap agreement" (language from H.R.4328). After a year of conflict, including a number of contentious Congressional hearings, in January of 1999, Brooksley Born announced she would not be seeking a second term as CFTC chair.

In November 1999, Clinton’s Treasury, Fed, SEC and new chair of the CFTC recommended to Congress in their joint OTC Derivatives Report to Congress that the CFTC be permanently barred from regulating most swaps. Congress eventually did so in the Commodity Futures Modernization Act of 2000:

The act has been cited as a public-policy decision significantly contributing to Enron’s bankruptcy in 2001 and the much broader liquidity crisis of September 2008 that led to the bankruptcy filing of Lehman Brothers and emergency Federal Reserve Bank loans to American International Group[1] and to the creation of the U.S. Emergency Economic Stabilization fund.

Throughout 2000 hearings were held on how to modify the Commodity Exchange Act and several bills were proposed but not passed. Finally, the Commodity Futures Modernization Act was introduced as H.R.5660 in the House on December 14, 2000 and as S.3283 in the Senate on December 15, 2000. Also on December 15, the House version of The Commodity Futures Modernization Act, over 100 pages long and, according to Michael Greenberger, written by investment bank lawyers was attached as a rider the Omnibus appropriations bill (H.R. 4577) while in conference. Later that day, just before adjourning for Christmas and less than 2 hours after it was reported out of committee, the conference report was passed by the House 292 – 60 and by unanimous consent by the Senate before the bill had even been reported to the Senate floor.

Michael Greenberger, who was at the time the director of the CFTC’s division of Trading and Markets, has said, "Quite frankly I think at the time anybody who opposed it was deemed to be a little bit crazy." Greenberger and his boss Brooksley Born at the CFTC were two within the Clinton administration who did oppose it.