In 2009, the John F Kennedy Profile in Courage Award, the nation's most
prestigious honor for public servants, was given to Brooksley Born for her role
in 1998, as chair of the Commodity Futures Trading Commission (CFTC), to try,
albeit unsuccessfully, to bring over-the-counter financial derivatives under
the regulatory control of the CFTC weeks before the collapse of Long-Term
Capital Management (LTCM).
OTC derivatives are contracts executed outside of the regulated exchange
environment and whose value depends on (or derives from) the value of an
underlying asset, reference rate or index. Market participants use these
instruments to perform a wide
variety of useful risk management functions. The Bank of International
Settlement (BIS) reports the notional value of outstanding OTC derivatives
contracts ending June 2009 to be US$49.2 trillion worldwide against a 2009
world gross domestic product (GDP) of $65.6 trillion.
The award citation read:
The government's failure to regulate such
financial deals has been widely criticized as one of the causes of the current
financial crisis. In the booming economic climate of the 1990s, Born battled
other regulators in the [Bill] Clinton administration, skeptical members of
Congress and lobbyists over the regulation of derivatives, warning that
unregulated financial contracts such as credit default swaps could pose grave
dangers to the economy. Her efforts brought fierce opposition from Wall Street
and from administration officials who believed deregulation was essential to
the extraordinary economic growth that was then in full bloom. Her adversaries
eventually passed legislation prohibiting the CFTC from any oversight of
financial derivatives during her term. She stepped down from the CFTC in 1999
and returned to a distinguished career in public interest law.
an attorney, was nominated as CFTC chair by Clinton on May 3, 1996, and
confirmed by the Senate on August 2, 1996, to a term expiring April 15, 1999
and stayed on to serve as acting chair until she resigned on June 1, 1999.
At CFTC, Born conducted a financial analysis that led her to anticipate a
serious financial crisis due to growth in the trade of unregulated derivatives.
Born was particularly concerned about swaps, financial instruments that are
traded over the counter on the dark market (trading on a cross network an
alternative trading system that matches buy and sell orders electronically for
execution without first routing the order to an exchange or other displayed
markets, such as an Electronic Communication Network, which displays a public
Instead, the order is either anonymously placed into a black box or flagged to
other participants of the crossing network. The advantage of the crossing
network to the transaction parties is the ability to execute a large block
order without impacting the public quote. Swaps thus have no transparency
except to the two counter-parties. The disadvantage to the market is that
material information is hidden from market participants.
On May 7, 1998, the CFTC under Born issued a "Concept Release Concerning OTC
Derivatives Market" requesting comments on whether the OTC derivatives market
was properly regulated under the existing exemptions of the Commodity Exchange
Act, a federal act passed during the New Deal era in 1936, and on whether
market developments required regulatory changes.
Greenspan, Summers, Levitt oppose regulation
Financial regulation, even against fraud, was strenuously opposed by then
Federal Reserve chairman Alan Greenspan, Treasury secretary Robert Rubin and
undersecretary Larry Summers, who is now the top economic policymaker in the
Barack Obama White House. On May 7, 1998, then Securities and Exchange
Commission chairman Arthur Levitt joined Rubin and Greenspan in objecting to
the issuance of the CFTC's Concept Release.
Their response off-handedly dismissed Born's concerns on inadequate regulation
on the ground that discussing the regulation of swaps and other OTC derivative
instruments would increase legal uncertainty of such instruments, potentially
creating turmoil in the already adequately self-regulated markets and reducing
the market value of these instruments. Further concerns voiced were that the
imposition of new regulatory constraints would stifle innovation and push
coveted transactions offshore through cross-border regulatory arbitrage.
In the Senate Agriculture Committee hearing on July 30, 1998, chairman Richard
G Lugar, Indiana Republican, attempted to extract a public promise from Born to
cease her campaign for regulation on the OTC derivative market in exchange for
warding off a move in Congress for a Treasury-backed bill to slap a moratorium
on further CFTC action.
To her credit, Born stood her ground, portraying her agency as being under
attack for carrying out its statutory mandate by anti-regulation agencies,
namely, the Fed, the Treasury and the SEC. Fed chairman Greenspan shot back
angrily that CFTC regulation was superfluous, and that existing laws were quite
adequate. "Regulation of derivatives transactions that are privately negotiated
by professionals is unnecessary," Greenspan said, referring to OTC derivatives,
adding, "Regulation that serves no useful purpose hinders the efficiency of
markets to enlarge standards of living."
According to Greenspan et al, the market can police itself even against fraud
because it is run by honorable people who have strong incentives to protect the
market from such fraud. But the issue at the hearing was more than bureaucratic
turf war. It was an ideological battle with the full power of the Federal
government siding with Wall Street to suppress the dutiful carrying out of the
statutory mandate of a small agency to protect the general public. Born was
effectively silenced by a concerted effort by top officials in the Clinton
administration after she responded to a challenge from a committee member on
what she was trying to protect by saying: "We're trying to protect the money of
Summers then as Treasury undersecretary, now top economic policymaker in the
Obama administration, was reportedly the Clinton administration's hatchet man
to shut up Born and shut down CFTC demands for regulation of the OTC
derivatives market. Born resigned as head of CFTC on June 1, 1999, in
After the global financial crisis of 2008, Greenspan has since publicly
confessed to Congress that he had erred in his judgment on the self-regulating
power of the market. It is not known if he has apologized to Ms Born personally
An October 2009 Public Broadcasting System Frontline documentary titled
"The Warning" described Born's failed efforts to regulate and bring
transparency to the secretive derivatives market, and noted the continuing
resistance to reform. The program concluded with Born sounding another warning:
"I think we will have continuing danger from these markets and that we will
have repeats of the financial crisis - [they] may differ in details but there
will be significant financial downturns and disasters attributed to this
regulatory gap, over and over, until we learn from experience"
Wendy and Phil Gramm
Before Born, Wendy Gramm served as chair of CFTC from 1988 to 1993. Gramm is an
economist and the wife of influential Republican Senator Phil Gramm of Texas.
Responding to an intense lobbying campaign from Enron, the CFTC under Gramm
exempted the energy trading company from regulation on energy derivatives
trading that was to contribute to the eventual collapse and bankruptcy of the
company in November 2001.
Wendy Gramm resigned from the CFTC in 1993 to accept a seat on the Enron board
of directors and to serve on its audit committee, for which she received $1.86
million. While on the Enron board, she received donations from Enron to support
the Mercatus Center at the conservative George Mason University on
"market-oriented research, education, and outreach think tanks that work with
policy experts, lobbyists, and government officials to connect academic
learning and real-world practice."
The Mercatus Center was founded by Rich Fink, former president of the Koch
Foundation, the philanthropic arm of Koch Industry, a private corporation based
in Wichita, Kansas, with subsidiaries involved in core industries that range
from commodities trading, petroleum, chemicals, energy, fiber, intermediates
and polymers, to minerals, fertilizers, pulp and paper, chemical technology
equipment, ranching, securities and finance, and other ventures and
investments. In 2008, it was the second largest privately held company in the
United States (after Cargill) with annual revenue of about $98 billion.
In 2001, the Office of Management and Budget (OMB) of the George W Bush White
House asked for public input on which Federal regulations should be revised or
suspended. Mercatus submitted 44 of the 71 proposals the OMB received. The
recommendations from Mercatus attacked Federal regulations such as a proposed
Interior Department rule prohibiting snowmobiles in Rocky Mountain National
Park, a Transportation Department rule limiting truckers' consecutive hours
behind the wheel without a rest, and a US Environmental Protection Agency rule
limiting the amount of arsenic in drinking water, not because these regulations
are bad for society, but that ideologically Mercatus believes such protection
should not be imposed by government and that the people should have the right
to chose for themselves whether they want to drink poisoned water.
The President's Working Group
The President's Working Group on Financial Markets (PWG), dubbed by a
Washington Post headline as the "Plunge Protection Team", was created by
executive order 12631 signed on March 18, 1988 by president Ronald Reagan after
the financial crisis of 1987 to give recommendations for legislative and
private sector solutions for "enhancing the integrity, efficiency, orderliness,
and competitiveness of [United States] financial markets and maintaining
PWG is chaired by the secretary of the Treasury, or his designee; and members
are the chairman of the board of governors of the Federal Reserve System, or
his designee; the chairman of the Security and Exchange Commission, or his
designee; and the chairman of the Commodity Futures Trading Commission, or his
designee. Born was a PWG member by virtue of her position as chair of CFTC.
In April 1999, the PWG issued a report on the lessons of LTCM collapse, Born's
last participation in the PWG before reigning two months later on June 1. The
report raised some alarm over excess leverage and the opaque risks of the OTC
derivatives market, but called for only one legislative change - a
recommendation that unregulated affiliates of brokerages be required to assess
and report their financial risk to government regulators. Fed chairman
Greenspan dissented even on that vague recommendation on the ground that
self-regulation was preferred.
Lessons of LTCM
Five months after the CFTC issued its Concept Release, CFTC chairperson Born
gave a talk on October 15, 1998, entitled "Lessons of Long-Term Capital
Management" at the Chicago Kent-IIT Commodity Law Institute in which she said:
"The events surrounding the financial difficulties of Long-Term Capital
Management LP ... raise a number of important issues relating to hedge funds
and to the increasing use of OTC derivatives by those funds and other
institutions in the global financial markets. Most of these issues were raised
by the Commission in its Concept Release on OTC Derivatives in May 1998. They
include lack of transparency, excessive leverage, insufficient prudential
controls, and the need for coordination and cooperation among international
On the lack of transparency, Born said: "While the CFTC and the US futures
exchanges had full and accurate information about LTCM's exchange-traded
futures positions through the CFTC's required large position reports, no
federal regulator received reports from LTCM on its OTC derivatives positions.
Notably, no reporting requirements are imposed on most OTC derivatives market
participants. This lack of basic information about the positions held by OTC
derivatives users and about the nature and extent of their exposures
potentially allows OTC derivatives market participants to take positions that
may threaten our regulated markets or, indeed, our economy without the
knowledge of any federal regulatory authority."
There are no requirements that a hedge fund like LTCM must provide disclosure
documents to its counterparties or investors concerning its positions,
exposures, or investment strategies. Even LTCM's major creditors did not have a
complete picture of LTCM's financial health. A hedge fund's derivatives
transactions have traditionally been treated as off-balance sheet transactions.
Therefore, even though some hedge funds like LTCM are registered with the
commission as commodity pool operators and are required to file annual
financial reports with the commission, those reports do not fully reveal their
OTC derivatives positions.
Unlike futures exchanges where bids and offers are quoted publicly, the OTC
derivatives market has little price transparency. Lack of price transparency
may aggravate problems arising from volatile markets because traders may be
unable accurately to judge the value of their positions or the amount owed to
them by their counterparties. Lack of price transparency also may contribute to
fraud and sales practice abuses, allowing OTC derivatives market participants
to be misled as to the value of their interests.