2000 Commodities Act Paved Way For Problems

MELISSA BLOCK, host:

This week, a guest on the program, lawyer John Martini, said the party ultimately responsible for this financial mess is Congress. He was referring to a law Congress passed in December 2000 that prevented regulation of the market for derivatives, including credit default swaps. We're going to hear more now about the effects of that law, the Commodity Futures Modernization Act, and the players behind it. We're joined by Michael Hirsh, who's written about this for Newsweek.

Thanks for coming in.

Mr. MICHAEL HIRSH (Reporter, Newsweek): Thanks for having me.

BLOCK: Why don't you talk about this period leading up to the passage of this law in 2000, and what was going on at that time with the derivatives market? How big was it?

Mr. HIRSH: Well, it was much smaller, much, much smaller. And that is the main claim that's made by those who were for deregulation, or lack of regulation at the time is that, you know, it was impossible to see this coming. But essentially, what happened is in 1998, in the spring of that year, Brooksley Born, who was then the chairwoman of the Commodity Futures Trading Commission, began to get increasingly worried about this market that was increasing in size and that was utterly unregulated by any government - derivatives, basically. And she developed a general proposal to begin the discussion of how to regulate the derivatives market. And that led to a very confrontational meeting of the President's Working Group when then-Treasury Secretary Bob Rubin and Alan Greenspan, the Federal Reserve chairman, told her that this was a very potentially damaging proposal, to even to begin discussing derivatives might drive the market overseas. And they quashed it, in effect.

BLOCK: And she was really a Cassandra-like voice at the time. She was predicting that, look, really bad things could happen here if we're not paying attention.

Mr. HIRSH: She was. I mean, it was very interesting. It was a clash of Wall Street and the legal world Brooksley Born was from. She was a lawyer through and through, and she was concerned that there simply wasn't a legal framework in place, whereas people like Rubin and Greenspan were, you know, much more creatures of Wall Street. And she lost that clash of culture. And then in the subsequent months, what happened was the President's Working Group met again in November '99 and agreed that credit default swaps should go largely unregulated. And that was influential in helping to pass the Commodity Futures Modernization Act a little over a year later, in late 2000.

BLOCK: Well, let's talk about that, that law. This was inserted - many, many pages inserted into a broader bill by then-Senator Phil Gramm, Republican of Texas. But it had the support of the Clinton administration, key players in the Clinton administration, and Democratic senators. How did it get passed? Was there debate? Was anybody paying attention?

Mr. HIRSH: Not really. I mean, it was stuck in the middle of this 10,000-page authorization bill, and it happened very quickly. I mean, I will say that the then-Treasury Secretary Larry Summers - who's now President Obama's chief economic advisor. Summers, who had replaced Rubin, did give testimony in which he said very plainly that he thought swaps should be largely unregulated as derivatives. He did give some caveats, saying, you know, we should keep some protections against fraud and manipulation and so on. But it did have his imprimatur and the letter from the Treasury Department supporting, for the most part, the Commodity Futures Modernization Act, as it was drafted, was used by Phil Gramm at the time as part of his campaign to help sell it.

BLOCK: The law is passed December 2000, derivatives credit default swaps remain unregulated. What happened with the market? Did it take off?

Mr. HIRSCH: Oh boy, did it ever. This was what, you know, what Wall Street wanted. I mean, this was the kind of market they wanted to create. There was, during this period, you know, from 2000 on up until the crash, a sense that this was helping everyone manage risk better. It was dispersing risk.

Little pieces of risk were being sliced up in derivative form and being sold around the world in the case of credit default swaps, like the ones sold by AIG. They were seen by those who bought them as a hedge against, you know, a downturn in these markets. And AIG had the notion that it could sell these to everybody without hedging itself because somehow it would never all collapse at once.

BLOCK: It couldn't fail.

Mr. HIRSCH: Right. The point is that no one had any sense of systemic risk, which we've now learned, you know, is really the culprit - that the whole market could simply collapse all at once, and that's precisely what happened.

BLOCK: We've been talking with Michael Hirsch, senior editor of Newsweek. Michael, thanks for coming in.

Mr. HIRSCH: Thank you very much.

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