Frontline's 'The Warning': Brooksley Born Was Right

Frontline states: In The Warning, veteran FRONTLINE producer Michael Kirk unearths the hidden history of the nation's worst financial crisis since the Great Depression. At the center of it all he finds Brooksley Born, who speaks for the first time on television about her failed campaign to regulate the secretive, multitrillion-dollar derivatives market whose crash helped trigger the financial collapse in the fall of 2008.

This program, which aired October 20, performs a public service by reporting the story of the heroic efforts of Brooksley Born, the former Chairman of the U.S. Commodities Futures Trading Commission (CFTC), to address the risks in the over-the-counter (OTC) derivatives market more than a decade ago.

Born's CFTC had the foresight and courage to issue a concept release in 1998 that asked the financial industry to do an analysis of the costs and benefits of potential regulation of OTC derivatives. Born had unwittingly taken a step that was seen by its opponents as the regulatory equivalent of South Carolina's firing on Fort Sumter in 1861 after seceding from the Union. In response, the financial industry declared regulatory war and set out to utterly vanquish the woman they saw as a dangerous rebel.

Wall Street lobbied with intense ferocity to convince Congress to strip the CFTC of its authority to regulate OTC derivatives and, thus, stop Born in her tracks. The Clinton Administration led the charge with Treasury Secretary Robert Rubin at the helm, along with his lieutenants Larry Summers and Timothy Geithner. They found an ally in Fed Chairman Alan Greenspan. Even Securities and Exchange Commission Chairman Arthur Levitt was brought to the task of persuading Congress; thankfully, he now regrets his role.

In the end Congress intervened to prevent the CFTC from moving forward with any OTC derivatives regulation. Utterly defeated, Born resigned as chairman in 1999.

One of the more troubling statements in the documentary was when Born remembered a conversation she had with Greenspan on the subject of potential fraud in OTC derivatives.

"Greenspan had an unusual take on market fraud," Born recounted: "He explained there wasn't a need for a law against fraud because if a floor broker was committing fraud, the customer would figure it out and stop doing business with him." Such a view of fraud is extremely naive and wrong.

We would like to know more about Greenspan's views on fraud and free markets. Unfortunately, Greenspan did not respond to the people doing the documentary to give his views -- no doubt, because they did not appear to be willing to be fair with Greenspan.

In fact, in spite of the wonderful job Frontline did putting this documentary together, it does have some shortcomings. Importantly, the overall story line is weakened by the bias against free markets generally, and against Greenspan specifically, woven generously into the narrative by the authors. The story line also suffers from a failure to fully see and appreciate the role of Wall Street players who were able to impose their will through old-fashioned political pressure and a masterful campaign of personal political destruction aimed at Born.

Republican free-market disciple Alan Greenspan is portrayed by Frontline as leading the charge against Born rather than Democrat Treasury Secretary Robert Rubin with his strong ties to Wall Street, for example. There is little doubt that Rubin took the lead, which is not to diminish the I'm-too-brilliant-to-be-ignored intimidation factor that Greenspan brought to bear with Born, quite unsuccessfully, which is a feather in Born's cap.

Further, Greenspan is portrayed as blinded by his ideology when he may merely have misapplied it. Much drama is attached to Greenspan's "confession" at a Congressional hearing in October 2008 where he said discovered a flaw in the theory that markets are always efficient and self-correcting.

Rubin is portrayed as one of many in Washington who had bought into the free market philosophy rather than being seen for what he was -- a powerful, well-placed actor diligently and effectively advocating for the self-interests of Wall Street and placing those interests over the public interest of the nation's economy and, ultimately, the American people.

To be sure, ideology played a prominent role in the arguments presented against regulation of OTC derivates. However, advocates of free market capitalism also generally believe that markets do not function if they are not transparent -- and the over-the-counter derivatives market was not, and is not, transparent. Therefore, it does not meet the definition of a free market. Thus, any appeals to free market capitalism to defeat Born's proposed regulation of OTC derivatives were mistaken and perhaps disingenuous and cynically employed by some of the participants.

The arguments against regulation of credit derivatives have focused on whether or not we should allow innovation. That's somewhat of a diversion, since the regulation of derivatives would not stop innovation. Further, innovations can be good or bad, honest or dishonest.

The OTC derivatives market has been and remains, in fact, extremely opaque and the instruments are extremely complex -- to the point that many, perhaps most buyers cannot understand the models that determine and price the risk in the derivative instruments. The market is ripe for manipulation and fraud, as had been illustrated sine the early 1990s when they blew up for some unfortunate clients of the derivatives group at Bankers Trust.

More importantly, the unregulated OTC derivatives market poses systemic risk, as demonstrated by Long-Term Capital Management, and more convincingly with the financial metldown of 2008.

If the OTC credit derivates market does not provide transparency and is too complex for market forces to function, then the people through their representative goverment, have the right to demand that regulators be empowered to shine a light into the black box of that market. Brooksley Born understood that straightforward idea when she raised the question about whether regulation was needed. When she stood alone against the array of opponents who attacked her, she quite properly earned the Profile in Courage award that was bestowed on her earlier this year by the John F. Kennedy Presidential Library.

So far, the public and media do not fathom the problems inherent in the OTC derivatives market and thus, there is no way to create public demand for the kind of regulation that could address the issues in the market.

Instead we have an understandable populist revolt over bonuses. Yet, the huge outcry over bonuses misses the point. Bonuses earned for a real reduction in risk or dispersal of risk for trades and financial instruments that add efficiency to the markets should not be an issue. Bonuses earned for OTC derivatives business deals that hoodwink clients and add systemic risk should be a problem. Bonuses for selling OTC derivatives that leave a growing stockpile of toxic assets should also be a problem. The bonus frenzy is a partly a result of the inability of Washington to see and act on the need to improve transparency and reduce fraud and improve pricing in these markets. Because the issues are not widely understood, the hounds baying at bonuses are chasing the wrong fox.

Another missing subtext here is the capture of the existing regulators by the institutions that face regulation. In this case, both the New York Fed and the Federal Reserve were naive about the dangers of OTC derivatives market and were fertile ground for pressure brought by the banks who are derivatives market players. The SEC was similarly snookered and lacking in curiosity.

Frontline's presentation of CFTC as an "obscure" minor player in the world of regulators is not exactly correct. It is an important agency and has a great track record as a regulator, unlike the SEC.

If the nation is now to successfully devise a new regulatory regime for financial institutions and financial markets, we need to get beyond the tiresome ideological mantra of regulation versus markets, which is often a false choice and which leads to new regulatory mistakes. Free markets cannot work without proper regulation and without sufficient transparency. We must also squarely address the problem of Wall Street's systemically risky, shall I say, and inordinate influence and its ability to corrupt the regulatory and political process in Washington.

The documentary claims to be reporting on "hidden history." There's nothing hidden about it. All the facts were there at the time. The media, including the financial media and Frontline, were simply asleep at the switch a decade ago. Today the same financial market ignorance prevails in the media and Congress, and there are few knowledgeable enough to be able to shed light into this black box.

Because of its ignorance and susceptibility to lobbying by special interests, Congress will likely devise new financial regulation which does not adequately address the issue -- while at the same time setting out on a course to load up on new regulations that do not appear to be likely to be effective or even useful and which are likely to be harmful, if not profoundly harmful.

Frontline does a service by drawing attention to the problem. Bravo! But, much more work needs to be done to address the issues raised in the documentary and others that were missed. The tentacles of Wall Street are still firmly in place and working to prevent the emergence of a robust regime of regulation of OTC derivatives. The Administration's proposals are not sufficient. And, Wall Street lobbyists are arrayed against even these inadequate provisions.

Copyright © 2009 by Robert Stowe England. All Rights Reserved.