Subprime mortgage backed securities, unlike the majority of derivative contracts, were a financial anomaly not classified as securities or insurance contracts. Brooksley Born, head of the Commodities Future Trading Commission (CFTC), sought financial regulatory supervision oversight responsibilities for subprime mortgage related credit derivatives. In a CFTC concept release, Chairman Born “was really terribly worried” that “the [over-the-counter (OTC) derivatives market has grown dramatically in both volume and variety of products offered and has attracted many new end-users of varying degrees of sophistication.”
Alan Greenspan and members of the Clinton White House’s President Working Group on Financial Markets fought against and rejected the recommendations of the CFTC. In a Joint Statement, members of the President’s Working Group expressed “serious doubts” about the CFTC concept release citing “grave concerns about the possible consequences” of the CFTC proposal because it “represent a significant departure from the careful approach” taken by other regulators to the OTC derivatives market.”
In testimony before the Senate Committee on Agriculture, Nutrition, and Forestry Arthur Levitt, Chairman U.S. Securities and Exchange Commission discarded the notion that CFTC should have regulatory jurisdiction over subprime OTC derivative markets. During the same hearing Treasury Deputy Secretary, Lawrence H. Summer testified that:
“Any disruption to this market brings two large potential costs. First, it could inhibit the use of an important risk management tool, thus reducing the efficiency our financial markets in channeling capital to its most effective use…Second, uncertainties of this kind threaten the position of the United States relative to other global trading centers, thereby depriving our economy of the multiple benefits which this activity affords.”
In a dissenting view, Brooksley Born testified before Congress that the CFTC “strongly believes that, in order to carry out its statutory mandate responsibility, it must keep its regulatory system in tune with changes in the markets it oversees.” She adds, failure to keep pace “would erode the regulatory system ability to protect customers and to preserve the financial integrity” of the OTC credit derivative markets.” In reaction to an earlier draft of President’s Working Groups report, Chairman Born urged Congress “to consider it very carefully.” Because the Working Groups position “would prevent the Commission from taking action in market or other emergencies arising in that portion of the OTC derivatives market” would “forbid the Commission from enforcing its existing laws and regulations relating to certain transactions in that market.” (See frontline report, for full historical narrative and discussion).
In a speech on financial derivatives, Federal Reserve Chairman Alan Greenspan would later add.
“By far the most significant event in finance during the past decade has been the extraordinary development and expansion of financial derivatives,” he said, “The fact that the OTC markets function quite effectively without the benefits of [CFTC regulation] provides a strong argument for the development of a less burdensome regime for exchange-trade financial derivates.”
In November 1999, the President’s Working Group released a major report declaring that over-the counter derivatives have “transformed the world of finance, increasing the range of financial products.” The President’s Working Group reached unanimous agreement that, in order “to promote innovation, competition, efficiency, liquidity, and transparency in OTC derivatives” it was necessary to provide “legal certainty for OTC derivatives” and remove “impediment to innovation” including the reduction of systemic risk by “removing legal obstacles to the development of appropriately regulated clearing systems.” In regards to “hybrid instruments” such as subprime credit derivatives. The Working Group conclude that the “CFTC will not propose any new rule relating to hybrid instruments without the concurrence of the other members of the Working Group.” William Rainer, Born’s replacement as head of the CFTC, signed off on the report.
On December 15, 2000, in a lame-duck session of Congress, Senator Phil Gramm, included the 262-page Commodity Futures Modernization Act (CFMA) into the Consolidated Appropriation Act omnibus spending bill for Fiscal Year 2001. In introducing this provision on the Senate floor, Senator Gramm, Chairman of the Senate banking committee included a provision that specifically restricted the CFTC, the Securities and Exchange Commission (SEC), or other financial regulatory agencies from oversight over the subprime OTC derivative market. Senator Gramm hailed the inclusion as a way to “protect financial institutions from overregulation” and “position our financial services industries to be world lenders into the new century.” Michael Greenberger, Professor at the University of Maryland School of Law and former Director of Trading and Markets at the CFTC, described the process in print and on the National Public Radio Terry Gross Show
In a 2002 letter to Berkshire Hathaway shareholders, Warren Buffett, the legionary investment banker, notably called OTC credit derivatives “financial weapons of mass destruction, carrying dangers” which, while then latent, were “potentially lethal.” Buffett also warned of the “mega-catastrophic risk” posed by the growing trade in derivative. Federal Reserve Chairman Alan Greenspan repeated his support for OTC credit derivatives, despite Buffett words of warning, in a 2003 speech on corporate governance.
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