All the Devils Are Here [66]
“I remember Bob at Goldman in the 1980s,” says a former colleague. “He was always the guy saying, ‘I’m not sure how much principal risk we should be taking with the derivatives book.’ When it got to be a $1 billion book, the traders wanted $2 billion. Bob would agree reluctantly. By the time Bob left, it was probably a $10 billion or $12 billion book. But Bob was always worried.”
His fear stemmed from something almost no one else in government could claim: actual experience with a derivatives meltdown. It happened in the late 1980s when a sudden, unexpected shift in interest rates—unforeseen by Goldman’s risk models, needless to say—wreaked havoc on the bond and derivatives markets. “Bonds and derivative products began to move in unexpected ways relative to each other because traders hadn’t focused on how these securities might behave under the extremely unlikely market conditions that were now occurring,” Rubin writes in his memoir. “Neither Steve nor I was an expert in this area, so our confusion was not surprising. But the people who traded these instruments did not fully understand these developments, either, and that was unsettling. You’d come to work thinking, We’ve lost a lot of money but the worst is finally behind us. Now what do we do? And then a new problem would develop. We didn’t know how to stop the process.” He concludes: “What happened to us represents a seeming tendency in human nature not to give appropriate weight to what might occur under remote, but potentially very damaging, circumstances.”
Once he got to Washington, Rubin found himself surrounded by people who viewed his lack of enthusiasm for derivatives as an amusing eccentricity. Most of the young turks he brought with him to Treasury were gung-ho about derivatives. His core group of young assistant secretaries—including a thirty-seven-year-old Treasury wunderkind named Timothy Geithner—approved of derivatives. Larry Summers used to tell Rubin that his attitude about derivatives was a little like a tennis player who wanted to keep using wooden rackets when everyone else had moved to graphite. And of course there was Greenspan, whose enthusiasm for derivatives knew no bounds. During the derivatives battles in the mid-1990s, dozens of officials from the Fed and Treasury—including Greenspan—testified in favor of unregulated derivatives and argued that the best thing the government could do was stay out of the way. Despite his qualms about derivatives, Rubin never once said anything publicly to contradict the Clinton administration party line.
Oddly enough, it was the SEC that sent the first shot across the bow: in December 1997, it proposed that the investment banks it supervised put their derivatives businesses in a separate unit, and register them—voluntarily!—with the agency. Under this plan, derivatives dealers would have capital requirements (but they would be lower than the parent firm’s!) and they would have to use risk models to calculate the riskiness of their derivatives book (but they could use their own internal VaR!). In fact, the derivatives transactions themselves wouldn’t even be regulated by the SEC. The plan was called “Broker-Dealer Lite.”
When the SEC put its plan out for public comment, Greenberger quickly drafted the CFTC’s response. Writing that the SEC proposal raised serious “jurisdiction” issues, the CFTC argued that if any agency should by rights be overseeing derivatives it should be the CFTC. Born would later say that she didn’t care who wound up regulating derivatives, so long as it was done right. The SEC’s “lite” approach hardly qualified. She then instructed Greenberger to draft a policy paper. The draft he came up with, thirty-three pages long, was called a concept release; it asked market participants and others a series of open-ended questions aimed at “reexamining” the agency’s approach to derivatives. Should players in the swap markets be required to report their positions to the government? Should swaps be sold through a central clearing