All the Devils Are Here [44]
The GAO’s report was far from a screed. “We were not against derivatives!” Bothwell says today. The report acknowledged how useful derivatives could be in managing risk. Still, Bothwell was stunned by what he had discovered. Brickell had consistently argued that since most derivatives dealers were banks, they were already regulated by the nation’s bank supervisors. But Bothwell quickly realized that securities firms and insurance companies were also diving into the derivatives business, and that the securities firms had set up separate derivatives affiliates to avoid SEC oversight. The insurance companies also set up separate subsidiaries, and state officials, who were in charge of regulating insurers, told the GAO that these new subsidiaries were outside their authority.
The GAO team was also concerned by the see-no-evil attitude of the derivatives dealers. For instance, Bothwell’s team asked the firms whether they were conducting stress tests on their portfolios, to gauge how they would do under “abnormal market conditions.” Roughly one-third of the respondents said the question didn’t even apply to them.
Most of all, the GAO was concerned about the elephant in the room: the possibility that derivatives posed systemic risk. Because the business was concentrated in a few hands, the failure of one dealer might “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,” the report said.
Yet despite these concerns, the recommendations made by the GAO were hardly radical. “What we are pitching,” Cecile Trop, the assistant director of the GAO, told Congress, “is an early warning system that will help in anticipating and responding to a financial system crisis, should there ever be one. That doesn’t sound too onerous to us; it’s a prudent and reasonable kind of approach.”
No sooner had the report been issued than the industry fired back. Immediately following its release, not one but six leading financial trade associations put out a joint statement that was nothing short of apocalyptic: “We are convinced that any legislation having these effects will harm the American economy.” ISDA issued a report about the GAO’s work, arguing that adopting the GAO’s suggestions would raise costs and reduce the availability of derivative products. It also said that the GAO had not proven that derivatives could create systemic risk. “The industry went after us and went after Congress to convince them that this was not a problem,” says Charles Bowsher, who was then the head of the GAO, and had been Bothwell’s only regulatory ally.
A month after issuing his report, Bothwell appeared as a witness before the House agriculture committee to defend it. (The agriculture committees in the House and Senate have jurisdiction over the CFTC.) As he walked into the hearing room, he was stunned at the line of people, most of them lobbyists, waiting to get in. There were cameras everywhere.
“What you see is that derivatives are growing up between the cracks in the regulatory system,” he testified. “No one really has the authority over that type of activity.”
Two years earlier, when Bothwell had testified about Fannie Mae and Freddie Mac, the response from Congress had been brutal. This was worse. The GAO produces “consistently overblown conclusions which are embarrassingly undersupported by the evidence and replete with undue editorializing,” said Congressman Earl Pomeroy, a Democrat from North Dakota. “We have to be careful about excessive regulatory regulation,” said Wayne Allard, a Republican from Colorado.
Then it was the regulators