Image via WikipediaEverybody thought Alan Greenspan is the greatest economist ever. He was on capital hill for FIVE presidents (started with President Gerald Ford, in fact). And he enjoys the Libertarian view of economic regulation: the less the better. In fact, he said so in his autobiography that he is a fan of Ayn Rand, who believes that government should NOT regulate the economy at all! As a direct result of that, his policy had encouraged the current toxic asset problem, and thus, the recession we all are stuck with right now.
Alan Greenspan was given post of Federal Reserve Chairman by president Reagan, and then, under Clinton as well. Clinton also appointed Bob Reuben as economic advisor, and later Treasury secretary. Both have made fortunes on Wall Street, and both decided to do a little as possible when it comes to regulations. Tim Geitner and Larry Somers are also of the same mind.
On the other side of Washington bureaucracy is a little known agency called CFTC, or Commodities and Futures Trade Commission. Their job is to oversee derivatives and agricultural futures, and its chairperson is Brooksley Born. She was one of the candidates for attorney general under Clinton, but when Janet Reno was chosen, she was offered chairperson of CFTC as sort of a consolation prize. She is a Securities lawyer by trade, and she is troubled by the vast use of derivatives on Wall Street.
Derivatives is basically any sort of financial instrument that is DERIVED from something else, such as asset, index, event, value, or condition. You can trade the derivatives, instead of trading the assets directly. One of the best known derivatives is stock options, another would be commodity futures, but there are many many more. In the most basic explanation, it is essentially a "bet", like "I bet you $5 that DJIA will reach 11000 by ______". In fact, a derivative can be based on another derivative, and new ones are created all the time by Wall Street.
Why so much derivatives? It is basicaly sold as a way to 'hedge' against calamities. As a quick example, say you have a lot of stocks, say, worth $10 million. You want to insure against it losing too much, so you "sell" a put option, which basically guards it against losing value. As prices go down, the put option's value rises, so your loss is mitigated. If the price does NOT go down, the option expires, and you just lose the fees and whatnot on it. In a way, it is insurance.
In another example, say a company had borrowed $1 million, and pays interest on it every six months, which is adjusted then. To "protect" itself from a suddenly hike in interest payment, they can buy a "forward rate agreement" from derivatives seller. If the interest doesn't change or actually goes down, the payment is forfeit. If the rate does go up, the seller of the agreement pays the difference in the interest payment. In a way, it can be considered as "insurance".
The main problem with derivatives is they are EXTREMELY volatile. Even a small change in price of the underlying "whatever" can have HUGE effect on the price of the derivative itself. And that will affect derivatives based on it as well. This allows for huge profits, and huge losses. And when you have derivatives based on derivatives, a small change will snowball into massive shakeups.
The problem in the 1990's is the derivatives are simply unregulated, or even, UNKNOWN to the government. The more complex it is, the more it was sold. Proctor & Gamble sued Banker's Trust for fraud, when Banker's Trust sold it a lot of OTC derivatives, and P&G lost millions. Trillions of dollars are traded every week in the derivatives market, and if something goes wrong, the whole financial system will go down, because banks will have lost too much money to keep running. Brooksley Born of CFTC decided to do something about it.
As Alan Greenspan and his "posse" are opposed to any sort of regulation on Wall Street, and CFTC is in the business of regulating derivatives, it is only a matter of time that they come into conflict. In fact, it was even rumored that Alan Greenspan actually had a bit of verbal sparring with Brooksley Born about how fraud should be handled. Supposedly, Alan Greenspan said that fraud should NOT be criminalized, and that the market will learn and stay away from the fraudsters.
CFTC had a "concept release" of the regulation written up, which is basically a draft regulation on how to regulate the derivatives industry. Alan Greenspan, Larry Somers, and Bob Reuban basically got VERY VERY upset, called in Brooksley Born, head of CFTC, and told her that CFTC will DESTROY the financial services market. Supposedly Bob Reuban told Brooksley Born that CFTC did NOT have the legal authority to regulate derivatives (even though it should be). When the concept release was published any way, SEC, Federal Reserve, and Department of Treasury actually issued a joint statement that CFTC should be SLAPPED DOWN HARD. However, CFTC is an indepedent agency that reports to the president, not to Dept of Treasury, only Congress can stop CFTC. Hundreds, if not thousands of lobbyists descended upon Capitol Hill, lobbying every congressman they can find. And in 1998, CFTC's advice was ignored.
Six weeks later, the LTCM hedge fund is about to go broke, losing millions every day, by investing in OTC derivatives internationally with HUGE amount of leverage. Nobody knew how it worked, yet with their reputation (2 Nobel laureats, one ex Fed Reserve vice chairman, and one ex investment house head) they were able to get 15 of the largest banks to invest a TON of money each, plus hundreds of the richest investors in the US. And if this fund go under, the entire US economy may collapse (Greenspan said so). It is going broke because its mathematical model it used to invest cannot cope with Russia defaulting on its loan obligations. The Feds ordered the banks each to put up MORE money (a couple hundred million EACH) to "buy out" the fund, thus solving this little problem, but not the underlying situation that caused the whole thing.
Congress started a series of hearings, but Alan Greespan held them off. The market was left to run by itself, even today.
Derivatives went up, and up... new derivatives are created based on more derivatives... and Wall Street also bet heavily on real estate, which can also be made into derivatives, known as "mortgage-backed securities". And in 2007/2008 the problem can no longer be hidden... The "toxic assets" of the banks are OTC derivatives, or specifically, "mortgage backed securities", and the ripples caused the recession. When banks panic, everybody else panics.
In hindsight, Brooksley Born's CFTC was prophetic in predicting the collapse of the OTC derivatives market, and its effect on the rest of the economy. Alan Greenspan was called back to Congress in 2008 for a hearing after his retirement from FedReserve in 2006, and it appears that Alan Greenspan was remorseful in allowing the market to run itself. Under questioning by hostile congressmen, Alan Greenspan had admitted that his world view was incomplete, and his "model was wrong" in allowing the market to run itself.
Obama and his staff (which includes many Greenspan proteges) have pledged to solve the problem and regulate the industry, but so far, the financial lobbyists have stalled the regulations. It appears that this legislation will pass in December, but substantially watered down.
(Reference PBS Frontline: The Warning)