Infectious Greed (27 page)

The GAO seemed to have the better argument. Mark-to-market procedures had been the sources of trouble at financial institutions since the days of Andy Krieger at Bankers Trust. The problem with companies keeping derivatives on their books at historical cost was that, as valuations changed, investors had no idea of the changes. ISDA was correct
that marking to market would make corporate earnings more volatile, but that was because corporate earnings
were
more volatile. Hiding the fluctuations didn't make a company any safer. ISDA's argument that only a fraction of the face value of derivatives was at risk also was correct. In fact, only a fraction of any investment—in derivatives or in stocks, bonds, or even real estate—was typically at risk at any point. But that didn't mean the investment was safe, or that the markets were small. Moreover, ISDA's two-percent number had ballooned after the Fed's rate hike, reflecting the losses from the rate hike. By March 1995, the percentage would be closer to four, or almost $2 trillion—arguably, more money than was at risk at any point in the entire U.S. bond market.
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Nevertheless, investors were too diffuse and poorly organized to counter ISDA's arguments. Economists and political scientists had long predicted that small, well-organized groups (such as ISDA) would prevent diffuse and poorly organized groups (such as investors) from achieving legislative reforms in their best interests.
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Whatever the merits of the debate, investors never had a chance.

As one show of ISDA's power, some of its lobbyists even persuaded journalists to stop using the word “derivatives,” which now had a negative connotation among the investing public. ISDA monitored the media carefully, and distributed press clippings on derivatives to all of its members. When ISDA's watchdogs found that
Wall Street Journal
reporters were continually using the “d-word” in covering the various derivatives scandals of 1994, they implored them to say “securities” instead.

For example,
Wall Street Journal
reporters originally had referred to Orange County's structured notes as “derivatives,” but stopped doing so at ISDA's suggestion. An ISDA director noted in a letter to Byron E. Calame, deputy managing editor of the
Journal,
that the “problem” had been corrected, and “that in your report about promising developments in Orange County's situation, the reporter never once used the word derivatives, referring to them only as securities.” When another reporter referred to complex instruments linked to the Mexican peso as “derivatives,” ISDA admonished Calame, “Because we read your newspaper and know that a lot of people rely on it to increase their understanding of financial activity, we think it's important that financial activities are accurately and consistently reported.”

The “d-word” began appearing much less frequently, especially in the
Wall Street Journal.
This was true even though the groups within banks
that sold the financial instruments at issue—including those related to Orange County and the Mexican peso—actually called themselves “derivatives” groups and referred to the financial instruments as “derivatives.” But investors didn't like that word, and ISDA wanted it expunged from the public record. (Ironically, ISDA had just added the word “derivative” to its own title, when it changed its name in 1993 from the International Swap Dealers Association to the International Swaps and Derivatives Association, in an attempt to show ISDA was more than just a lobbying vehicle for the top swap dealers.)
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The derivatives lobby occasionally was as inaccurate as it was aggressive. For example, Warren Heller, director of a research firm called Veribanc Inc., quickly became popular among derivatives dealers when he published a study in the fall of 1994 saying that banks were not at risk from their derivatives activities. It turned out that Heller had made a glaring error, counting only the contracts on which banks had a net gain, not those on which the banks had a net loss.
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But few investors had the resources to find the error, and point it out.

Jim Leach was one of the few members of Congress who consistently stood up to the lobbyists at ISDA (others included Democratic Representatives Henry Gonzales and Edward Markey). In 1994, he introduced derivatives legislation, based on his staff's 900-page study of the market. Mark Brickell battled Leach, making arguments—to various members of Congress and the media—that included serious misstatements of fact. For example, Brickell said that Leach's bill would impose a suitability standard on derivatives “that is not applied to any other area of finance”; in fact, the standard was no different from the applicable standard in other areas, such as the rules for banks and savings and loans. Brickell also complained about the Leach bill's supposed capital standards for swaps, when in fact the bill contained no such provisions.

At a July 12, 1994, hearing on the bill, Representative Leach finally lost his patience with Brickell. Congressional hearings are typically scripted, calm affairs, but this time Leach blasted Brickell, accusing him of lying about provisions of the derivatives bill Leach had proposed.
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Leach said, “You are quoted yesterday in the
American Banker
that banks could become liable for every derivatives contract that loses money. Well, I would like to know where in my bill it says that. That is a very powerful statement and one that is false. What section of the bill is this in? I mean, I and my staff wrote the bill. I don't recall putting it in.” Leach said his bill's provision on suitability was the same as the standards
already imposed by the Office of the Comptroller, and he noted that capital standards for swaps were not even in the bill. He admonished Brickell, “If you're going to be a constructive engager in making recommendations to this Congress that carry weight, I would recommend that you state valid objections.”
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When Brickell attempted to defend himself by noting that Leach's bill treated derivatives differently than other securities, Leach lashed out again, telling him that “derivatives are new, they are off balance sheet, they are a totally different dimension, and your bank has been in the lead in suggesting that.”
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Brickell said he didn't take the attacks personally, but he gave up trying to persuade Leach. Instead, Brickell shifted his focus to other legislators. Brickell had alienated a few staff members of the Senate banking committee, who refused to meet with J. P. Morgan officials until they were assured Brickell was out of town (they were worried Brickell “might cause a scene in the halls”).
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But he persuaded many other members of Congress that Leach's bill was premature and would be counterproductive. He argued that regulation of derivatives, including swaps, was unnecessary, and focused on how derivatives were used to hedge, ignoring their speculative uses. He said, “Swaps guys may be clever characters, but we haven't been able to invent new kinds of risk. What swaps have allowed us to do is tear apart different sorts of risk, isolate them, and manage them independently.”
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Brickell had plenty of help from Arthur Levitt, who suggested, in August 1994, that it would be better for the top derivatives dealers to regulate themselves. Levitt urged the dealers to form a self-regulatory “Derivatives Policy Group,” and said legislation should wait until that group had decided on a plan.

Brickell also received help from several former and soon-to-be-former regulators. Gerald Corrigan, who had issued so many warnings about derivatives as head of the New York Fed, had just left for a much-higher-paid position at Goldman Sachs, and he was named co-chairman of the Derivatives Policy Group, which was lobbying for self-regulation. Wendy Gramm, the former CFTC chair and board member of Enron, praised Brickell and said that he and ISDA “could have been even tougher in terms of their position.”
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Gramm wrote an opinion piece in the
Wall Street Journal
entitled “The Good Derivatives Do,” in which she argued, “If another major default or market shock occurs, we must all resist the urge to find scapegoats, or to over-regulate what we just do not understand.” Frank N. Newman, the Treasury undersecretary for
domestic finance, lobbied Congress in a September 16, 1994, letter, to “indefinitely postpone” derivatives legislation in light of the progress being made in the private sector. (Newman's comments were a job interview of sorts; he would soon leave to become the head of Bankers Trust, where he would be paid more money than former chairman Charlie Sanford had ever dreamed of making.)

With this assistance, Brickell and ISDA stopped the derivatives legislation. Brickell was obviously pleased and confident, calling the opposition to derivatives regulation a “consensus.”
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He belittled members of Congress who had continued to support new laws during the 1994 hearings on the legislation, and who failed to draw a distinction between structured notes and swaps, saying, “I don't know how they even realized it during the hearings, but none of the investors were talking about the use of swaps.”
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Just before the 1994 elections, Brickell predicted a Republican victory, saying, “I suspect that after Nov. 8, we'll be dealing with a very different Congress.”
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Many prominent regulators were surprised that more members of Congress hadn't supported some new legislation, given the magnitude of the losses and the widespread, unseemly behavior of many Wall Street bankers. As David Mullins Jr., former vice chairman of the New York Fed and later a partner of Long-Term Capital Management, put it, “Given the steady stream of reported losses and all the publicity, there's been surprisingly little steam for legislation.”
Institutional Investor
magazine, a prominent Wall Street publication, gave the credit to ISDA.
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In 1995, the prospects for new derivatives legislation declined even more. President Clinton appointed Robert Rubin—the ex-chairman of Goldman Sachs—to replace Lloyd Bentsen as Treasury secretary, and Rubin joined the band of regulators opposing new laws.

Four bills were proposed during the 1995 Congress. Jim Leach introduced a new version of his 1994 bill, proposing a “Federal Derivatives Commission” to regulate the markets.
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Henry Gonzales introduced a bill requiring companies to disclose their derivatives investments, and coordinating federal regulation of derivatives.
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Democratic Senator Byron L. Dorgan, of North Dakota, introduced a bill to prevent federally insured banks from speculating using derivatives.
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And Democratic Senator Edward Markey, of Massachusetts, introduced a bill to bring derivatives dealers into a regulatory framework similar to that for securities generally.
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All the bills died. Brickell's prediction about Congress becoming more
sympathetic had come true. By 1995, the losses from the Fed's rate hike were a distant memory. There had been no obvious financial crisis. The markets hadn't crashed. And derivatives reform was not part of the “Contract with America,” the agreement among Republicans who now controlled Congress. Perhaps most important, the private sector had responded to Arthur Levitt's request for self-regulatory reforms. On March 9, 1995, the Derivatives Policy Group—the six top Wall Street firms in the over-the-counter derivatives markets—agreed to a “Framework for Voluntary Oversight,” a document in which the dealers pledged to improve internal controls and risk management, and to report more quantitative data privately to federal regulators.

 

 

A
lthough Congress supported self-regulation by derivatives dealers, it sharply questioned efforts by a private self-regulatory accounting group to create new disclosure requirements for some financial instruments. Many of the questionable accounting practices that would plague the financial markets during the late 1990s and early 2000s grew out of these failed efforts.

Since 1973, the Financial Accounting Standards Board had set accounting policy for U.S. companies, telling them what information they needed to disclose to their investors. In the alphabet soup of accounting, FASB established GAAP (
Generally Accepted Accounting Principles
), the basic rules of accounting practice, which were a key factor in persuading investors that the stock prices of companies traded in U.S. markets were fair and accurate.

For their first two decades, FASB and GAAP worked reasonably well. But by the early 1990s, accounting rules had fallen well behind financial innovation. Many experts said that if you asked all of the Big Five accounting firms a question about a complex accounting issue involving new financial instruments, you would get five different answers.

Anyone who had looked at a corporate annual report understood the problem. According to a survey by Ernst & Young, the length of an average annual report had increased from thirty-five pages, when FASB first began setting accounting rules, to sixty-four pages in the early 1990s. The number of footnotes was up from four to seventeen. Ray J. Groves, the chairman of Ernst & Young, warned that “we can expect to see even fatter and more unreadable annual reports in the future. Readers will decide to ignore them, as many people already do.”
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Even as the amount of disclosure increased, the reports became less useful, especially as to complex financial products. In response to a question raised at an ISDA conference, Ethan M. Heisler, a vice president at Salomon Brothers, expressed skepticism that even sophisticated securities analysts could draw anything of value out of financial disclosures about derivatives: “Show me an equity analyst who has taken the disclosures that you currently have on derivatives and made any kind of meaningful use out of those disclosures. I would challenge you to find it. I have never seen it.”
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