Michael Greenberger is interviewed by WHYY's Terry Gross.
Terry Gross: The American financial system has been in trouble. And the reasons why are a little difficult to comprehend. They involve derivatives, credit default swaps, hedge funds and all sorts of complicated trades that are unlike stocks and bonds. Our guest, Michael Greenberger, can explain how we got into this mess in language that people who aren’t finance experts can understand. He served on the Commodity Futures Trading Commission from 1997 to 1999 where he directed the Division of Trading and Markets. He was responsible for supervising exchange traded futures and derivatives. He also served on the steering committee of the president’s Working Group on Financial Markets and the International Organization of Securities Commissions Hedge Fund Task Force. He now directs the Center for Health and Homeland Security at the University of Maryland where he’s a professor at the School of Law. … Michael Greenberg, welcome to Fresh Air! Why is part of the finance system now being described by so many people as a “shadow financial system”? That has a nice conspiratorial ring to it!
Michael Greenberger: Well, the reason for that is that most people in their every day contact with the financial system know about stocks and bonds. They can open their newspapers and/or get on the internet and get pricing information and about where a stock is in terms of its price level or what a bond is selling at. And even in the traditional futures market, for example, for farmers who are hedging their crops and wanting to lock in at a certain price – or even those who want to speculate in the futures market. That’s all a transparent market. You can go to your computer. You can go to your newspaper. You will find out immediately what is going on. Supplementary to that there is financial reporting about that system. But since the late 1980’s a much more powerful system has developed and that’s often referred to as “complex derivatives.” The banking community developed these products starting in the mid-80’s and it’s just developed a head of steam since that time. At this point, worldwide, there is more money invested in derivative products that there are in socks and bonds – which usually comes as a great surprise to many people. These derivative products, when boiled down to their fundamentals, are essentially bets on the direction that certain event will take. The most common, for example, is betting on the direction of interest rates, whether US interests rates or worldwide interest rates. It’s a private contract. One side enters into a bet that the interest rates will go up. The counter party – the other side – bets that they will go down. Those are private transactions. They’re not easily made public. You can’t open the newspaper and see what’s happening. When you enter into a bet, if you want to get, the counter party who takes the opposite end charges you a fee for having that bet. It’s a very profitable piece of business for banks and hedge funds to do. That’s why this is called a “shadow system.” We don’t see it in our day-to-day lives and it goes on in what people refer to as “dark markets.”
TG: And there’s no regulation.
MG: There is no regulation. In fact, when I was in the government, we argued very strenuously that these kinds of hidden bets could be very disruptive to the financial system and they played as important a role as securities and bonds did – which are regulated. We wanted them to be regulated. That was a battle that we lost out on. In December, 2000, on the floor of the Senate, Phil Gramm, chairman of the Senate Finance Committee, introduced a piece of legislation that completely deregulated these markets not only at the federal level but, for the most part, at the state level. So they are completely outside the law, so to speak.
TG: What was this legislation?
MG: It was called the “Commodity Futures Modernization Act.” It was a 262-page bill added as a rider to an 11,000-page omnibus appropriations bill as Congress was recessing for Christmas in 2000. I would say there was no one except the drafters of the bill who understood what it did. I can assure you that the drafters of the bill were not members of Congress! They were the lawyers for the investment bankers on Wall Street. They convinced Senator Gramm to introduce this. They freed the system from any regulation. And we’ve been embarking on financial fiascos ever since.
TG: I should mention that Phil Gramm is now the chief economic adviser to John McCain in McCain’s presidential campaign!
MG: He is the chief economic adviser to John McCain. John McCain famously said quite recently he doesn’t really know as much as he should about economics, but he’s reading Alan Greenspan’s biography! Phil Gramm is at his side. Phil Gramm is also an officer of UBS, the Swiss bank, that just – within these last few days – reported losses in the neighborhood of $12 billion because of these bets.
TG: Let me see if I can understand this credit derivative – these complex credit derivative bets a little bit better. Is credit derivative the right word?
MG: Credit derivative, credit default swaps, OTC derivatives – are the words that you will hear when federal financial regulators speak.
TG: It seems to me, if I understand it correctly (and I’m not sure that I do!), that, say, you can invest in a … basketball team! There’d be the stock market way of investing in the actual team. But the credit derivative approach would just be betting on whether the team was going to win or lose.
MG: That’s a very apt analogy. That’s exactly right. Instead of owning the team, you go and find either a legal or illegal gambling operation and you try and profit from team by betting that they will win or betting that they will lose. And in the present crisis the bets that are at stake are bets on whether people would pay their sub prime mortgages off or whether they wouldn’t. For the most part, the banks had bet that the sub prime mortgages would be paid off because they thought it was a riskless investment. Housing markets were always going up astronomically and even people who couldn’t afford their mortgages within a matter of months had gained value in their real estate so that the value could be extracted and they would then have money to pay mortgages off that they didn’t have to pay off when they started out with the loan. So the banks entered into a series of bets that those sub prime mortgages would be paid off and when you hear that they’re losing millions and billions of dollars it’s because those bets have turned bad. Essentially, it’s even worse than the fact that they’re losing bets. They took these bets just as if you went to a basketball game and bet on a team to win. They took those bets and said, “Wow! These are very valuable bets. We’re going to add them as assets to our books. We think these are so risk-free that they have tremendous value. So when you read a bank’s financial statement, that’s listed as a very valuable asset. When it turned out that these bets were going to be lost, that bookkeeping had to be redone. Instead of being a valuable asset, it was a very bad liability. To make matters worse, the federal government permitted these institutions to engage in this betting not through the bank itself or through the hedge fund itself, but through off-book entities called “structured investment vehicles.” So, for a long time, when the banks were losing this money, they didn’t even put it on their balance sheet. When you hear, for example, that a bank has lose billions of dollars, that is merely the money it has put back on its books. There may be even greater losses in these structured investment vehicles. The banks have been consistently urged to fess up and tell the world what their losses are so that we can draw a ring around the extent of this problem.
TG: So what you’re telling me is that a lot of the things that have crashed our economy are basically just bets! They’re not even about businesses not doing well because their products aren’t selling and therefore investors are suffering. This is betting!
MG: It’s exactly betting. In some sense, there’s financial prudence in this. For example, if you owned the sub prime mortgage – or the asset value of the sub prime mortgage – and you were worried about that it might collapse, you would want to pay a very small premium for an insurance policy that if your investment collapsed you would be insured and you would not lose any money. The bank entered into a bet that it would never have to pay off that insurance. And those are called “credit default swaps.” For a very small amount of money, they effectively gave investors insurance policies that the assets they held depending on the sub prime mortgages, would never lose value. That’s the bet that was made here. The form of the bet, technically speaking, is a credit default swap. By the way, it sounds an awful lot like an insurance policy but they don’t want to call it insurance. If it’s insurance, it’s regulated by the states. So they were very careful, whenever they wrote these contracts, to make clear that the word “insurance” never appeared. If you were doing insurance, the states would then have a very aggressive role to play. And in fact, if I may just add, when they made these bets and they got worried whether they’d be able to pay them off if the sub prime mortgagee failed, they went out and got insurance policies to protect the value of their bet. If they lost the bet and they had to pay, they were insured against that lost. But when they went to those insurance companies they said, “Please don’t write us an insurance policy. We want a credit default swap.” Why? Because credit default swaps are expressly deregulated by federal statute and cannot be regulated by the federal government or by the states. The final tragedy is the insurance companies thought they were insuring a risk-free insurance factor. So they gave out insurance faster than they could write it. So you had these very small companies insuring billions and billions of dollars of these bets. You will read – eight weeks ago we read a lot about – these insurance companies are beginning to fail. And the taxpayer has problem there because most of these insurance companies had guaranteed municipal and state obligations. That is to say, taxpayers have paid to have their public bonds insured by these companies. Now they have failed. The states and cities don’t have the insurance they need. So they have to go out and buy insurance from companies who are sound and there is an additional premium that has to be paid. State treasurers – for example, the California state treasurer – is beside himself over this problem.
TG: … The trouble isn’t over yet.
MG: We’re soon going to find out it’s not just mortgages but all kinds of loans. Credit card loans, student loans, auto loans are all going to be infected. The same system is at play. And the thing to understand here is that this all started out and it all seemed like a wonderful, wonderful idea. The banks were making loans in the form of mortgages. Traditionally, when I took my mortgage out many years ago, the bank was very careful to see that I could pay it off. The bank was going to lose money if I didn’t. What has happened is the banks have decided, “Look, we’re going to make the loan. We’re going to get all the commissions, the fees, the courier service charges, and the back charges. But then we’re going to sell the loan to other people through a security. That’s what you hear called “mortgage backed securities.” They bundle the loans together and – just like a corporation – investors can by those securities. Well, the investors said, “Wait a minute! If we buy securities for people who can’t afford to pay them off, that’s a very risky operation. “ And that’s when the banks said, “Not to worry – we’ll effectively insure them. We’ll guarantee that they’ll be paid off for a very small premium.” There’s no general reporting system. Nobody, including the Fed, can go and say, “How many of these bad bets are out there?” So, for example, when Bear Stearns went under because of these bad bets and the American public had to take these bets – these credit default swaps – as collateral, no one else would take them as collateral, just the US taxpayer. Ordered by the US Treasury to do so, the taxpayer takes it as collateral through the Fed, loans Bear Stearns $30 billion, and within the last few days the market went up 391 points, and people are saying to themselves, “Wow! The problem’s cured!” But the next day, people realized, “We don’t know if Bear Stearns is the mine disaster or the canary in the mine telling us about a much bigger disaster.” And that’s the problem.
TG: Well, that leads me to something you said a few moments ago which I found kind of scary. You said we’ve seen what happened with the sub prime mortgages, but we haven’t yet seen the similar damages with credit card loans and automobile loans…
MG: …student loans… And also the private equity. All these people who borrowed money to buy these corporations have all followed the same template. Obviously I’m simplifying it for your audience. But really, when you break it down to the fundamentals, whatever my simplification is, it’s exactly what’s happening. It’s as if a bunch of Las Vegas bookies started taking bets but never bothered to write them down or record them. Or, as you know, frequently a bookie will try and have a balance book so that if he loses one side of the bet he will cover with another side of the bet and they make their money on the commissions, or the “vig” as they say. Here these banks didn’t bother to hedge themselves. We would have been better off if Las Vegas had handled this operation than having Bear Stearns.
TG: I can’t imagine how complicated the math is that goes into figuring out these complicated investment instruments. So in addition to deregulation making this environment possible, probably computers have too? It would be impossible to keep track of these complicated mathematical formulas and bets.
MG: That’s a very interesting query. First of all, the instruments themselves and how they pay off – in other words, who wins or loses – are complicated. But the concept is not complicated. And of course the American public is totally scratching its head over this and doesn’t know what’s happening when they see people losing homes. Those people lost homes because the banks really didn’t have any risk here. They were making commissions on the mortgages themselves so they just wanted to write this stuff as fast as they could and they didn’t care whether these people could pay off! So those people who didn’t have the wherewithal to pay off have now been foreclosed upon. Neighborhoods have empty houses. People are beside themselves. But it all goes back to the fact that there were these underlying credit default swaps. The American people don’t understand that. If Franklin Delano Roosevelt were president right now, we would understand that. There would be a fireside chat. We would make it so that the American public understands it. And it’s important that the American public understand it because, even as we speak, the Wall Street interests who have all the money in the world to hire lobbyists, are lobbying 24 hours a day, 7 days a week, 365 days a year … to keep this market what we began our discussion with: a shadow market that nobody understands. What they tell Congress is, “Look, these are complicated things. You are not smart enough to tell us what to do!” But the fact of the matter is, what we have seen is these guys are not smart enough to be able to carry this thing off without regulation. They’re losing money hand over fist. Of course, the saddest fact in all this is that when these CEO’s lose the money they’re fired. But they walk away with hundreds of millions of dollars in severance packages. When Bear Stearns collapses, the Fed is prepared to have taxpayer money thrown in to rescue the institution but no money or relief goes to the person whose mortgage has been foreclosed.
TG: You’ve explained some of the derivatives and other complicated investment instruments behind the financial problems we’ve been having in the past few months. You described how Phil Gramm, when as a Republican Senator from Texas, he was behind a Commodity Futures Modernization Act that prevented regulatory agencies from regulating these complicated instruments. Phil Gramm was also behind a bill that was passed in 1999 overturning a Depression-era bill that regulated investment banks. Tell us a little about that bill.
MG: As a result of the Glass-Steagall Act which was passed during the Depression, there were two kinds of banks: depository institutions, which are the kinds of banks we’re most familiar with where you go in and open a checking account or saving account, or try to get a loan; and investment banks, which don’t take deposits but have investors, and they are responsible for making investments in financial instruments. The Glass-Steagall Act said where people are putting their money – their savings – we don’t want these guys doing risky kinds of stock market investments. Today the problem is derivatives. In the ‘30’s it was stocks which were not regulated. So we want to separate the two out so people understand that when the go to a bank and open a savings account, the bosses of the bank aren’t fooling around with the stock market. Well, over time the banks were not happy with that and they wore that distinction away. So in 1999 any distinction between an investment bank and a depository institution was eliminated. That allowed the banks that we’re familiar with – like Citibank or CitiGroup or Bank of America or Wachovia – to have an arm, which does all of these fancy investments. And the theory for all of this is that these bankers are very, very smart. They make a lot of money. They dress nicely. They have nice summer homes. They’re not going to risk their money. They’re smarter than the Congress is. So for years and years and years, the markets have been deregulated. In fact, earlier this week, Secretary Paulson announced this restructuring of financial regulations. That really started before the sub prime mess. It was the result of Wall Street saying, “Hey! We are so heavily regulated in the US, we’re losing business to London. We’re no longer going to be the financial center of the world. We need a lighter touch of regulation.” And that was set in motion in March of 2007. What was shocking to me was that Paulson introduces this legislation, which was modeled after the British template – which is light regulation of financial institutions. It has nothing to do with the sub prime meltdown. It heads in the other direction of being a lighter regulatory touch. Ironically the British are reeling from their regulatory system. One of the major banks in Britain – Northern Rock – had a classic Depression-era run where people lined up outside to get their money out of the bank. They were heavily into the sub prime market. The bank virtually collapsed. The British government had to buy the bank – they nationalized it. So the irony is that the more you argue for deregulation, the more you end up having government-owned entities. Which is not good for anybody! It’s especially not good for the American taxpayer. The American taxpayer is buying these banks, instruments, and everything else when they had nothing to do with the collapse.
TG: The Fed bailed out Bear Stearns with the explanation that if it didn’t if would have been disastrous for the American economy and possibly for the global economy. Do you think that’s a legitimate argument?
MG: I absolutely think it is a legitimate argument! There’s no doubt about it. If Bear Stearns had collapsed, it would have been a house of cards. Others would have collapsed. It wouldn’t have just been a US problem, it would have been a worldwide problem. The point is, don’t put us in the position where somebody is too big to fail. There was an interesting article in the New York Times, roughly about December 21, 2007, called “The Fed Shrugged.” It’s a play on Ayn Rand’s “Atlas Shrugged.” Alan Greenspan, when he was there, and Bernanke now, have been warned about this not just by anybody but also by other people in the Bush administration – that, as early as 2001, we had a crisis on our hands. If the federal government had acted responsibly, this would not have happened. We would be in a very good economy now with job growth and income growth. But yes, that’s why when people tell you this is the worst economic crisis since World War II, that’s a way of not saying the panicky thing, which is that we may be heading for a depression. If a Bear Stearns collapses, you’re going back to 1929. It’s not just Bear Stearns, it’s a house of cards. That’s what we don’t know. Is Bear Stearns the end? That’s why the market went up so much earlier this week on the belief that Bear Stearns is the end. Some of us are very worried that Bear Stearns is the beginning and not the end. If we needed $30 billion to bail out Bear Stearns and there are others that start collapsing and need to be rescued so we don’t go into a total abyss, it’s going to be a major crisis. They did the right thing when they faced the ultimate crisis. Where they were wrong is not responding to the clear signals going all the way back to 2001 that this was going to happen if the Fed didn’t intervene sooner.
TG: A lot of people are saying that if the Fed and the taxpayer’s going to bail out an investment bank, then the government should have the right to regulate investment banks just as the government regulates commercial banks. What are some of the proposals on the table now to do that?
MG: Frankly, I have to be quick to answer that I don’t think there’s any effective proposal on the table. First of all, my own view is that between the two pieces of legislation, the more famous one – which was eliminating the distinction between investment banks and commercial banks – was the least problematic. The lesser known piece of legislation – Phil Gramm-sponsored – which had no hearings in the Senate, no Senate report, came up on the floor, was really just a complete surprise to everybody, is this deregulation of these instruments – the credit default swaps, OTC derivatives, etc. My view is that I don’t care who the institution is – whether it’s a bank, investment bank, hedge fund, private investor. What I care about is that these are toxic investments that have been deregulated without any forethought at all except forethought by Wall Street. Warren Buffett famously said that these OTC derivatives – credit default swaps – are the financial equivalent of weapons of mass destruction! He found that out because he bought a company that he did not realize, when he bought it, was heavily involved in all these derivatives. He had to unwind them. It took years and years and he lost a lot of money. He has become one of the foremost advocates for regulating these products. There’s a lot of discussion about helping homeowners. In the Senate now there’s been some kind of compromise reached. Helping homeowners is great – it needs to be done! But what also needs to be done is to eliminate the ability of banks and other lenders not to worry about whether the loan they’re making is going to be paid off. What is happened is that it has removed financial discipline from the market, and the people who do these loans are making all the money on the commissions from the loan transaction itself. They could care less about the interest rate being paid. And then they want to shift the loan out into the economy and have others worry about it. That has removed the kind of solid discipline that lenders usually employ. That was the historic way that financial discipline played itself out in the system. But once you took the worry about whether the loan would be repaid out of the system, all these lending institutions wanted to do was make these transactions. So they falsified papers and everything else, let people submit unverified information, to get these loans out the door. And now the piper is being paid. My view is that it was all done because they had these tricky little instruments that they thought would save the day. They didn’t. They’re the heart of the problem. Where we need to go back to is where life was on November 2000 when these instruments were subject to regulation.
TG: You said that Henry Paulson, Secretary of the Treasury – that his new proposal to regulate financial systems in the US is actually more like deregulation than more regulation! Would you explain that?
MG: That’s absolutely true. As I said earlier, it arises from a pre-meltdown scenario where the economy was doing rather well and the investment interests on Wall Street wanted to be regulated less harshly by the US government. They put in motion this review of financial architecture of the US. Paulson grabbed onto it, hook, line and sinker. He started a study. And the report, earlier this week, was the end result of a study that was done before the meltdown had occurred and by Paulson’s own admission was not written with an eye towards solving the problems that we’re facing on a day-to-day basis right now. The reason it’s a deregulatory measure is that it puts all the responsibility ultimately in the hands of the Fed. It doesn’t give the Fed the power to prevent problems from happening, it gives the Fed the power to deal with problems as they occur. In other words, taking Bear Stearns as an example, the Fed wouldn’t have had the power to deal with Bear Stearns as it was getting into its problems. But once Bear Stearns wanted to call a time out to prevent financial disaster, at that point the Fed would intervene, do all these investigations, and look at the books and everything else. It takes power away from the states and their regulatory abilities. And because of that, the states’ attorneys general and insurance commissioners are very upset about this. In a very complicated and deft way, it takes power away from the SEC by telling the SEC, “You’ve been regulating too restrictively. You have to have a much lighter touch.” Within six hours of him announcing this, there were so many vested interests that were challenged – the states, the SEC. Even the Fed in the end started making noises because while it became the super cop it would have less tools available to it if the proposal were not adopted.
TG: Is there a counter proposal?
MG: First of all, it seems to me that the Paulson proposal is virtually dead on arrival. My own view is that Paulson damaged himself very seriously by engaging in this effort. It’s like being in the middle of World War II and talking about how you’re going to rearrange the Pentagon after the war is over rather than saying how we’re going to defeat the Nazis and the Japanese. Just to emphasize that point: when Congress went out on recess, they got earfuls about the people being upset, worried about this problem, The foreclosures, the Bear Stearns bailout have really touched a nerve. Even the Republicans have come back upset. Bernanke had to meet with House Republicans yesterday because they believed this could be a political catastrophe for the Republican party because it’s their watch. Unfortunately, as we sit here today, the proposals that are on the table are, I believe, mere bandaids. I think as this problem gets worse and worse -- unfortunately we have to wait for that to happen -- we will start getting more serious proposals from Congress on how to deal with it.
TG: I have a question that only a person who doesn’t really understand the finance system would ask! And that is, where’s all the money that disappeared? There are so many investment banks where each of the banks lost billions of dollars. So where’s the money? Does somebody else have it? Did this money ever exist in the first place?
MG: That’s a very interesting question. The answer is yes, someone has it. These were bets. Some people won those bets. There were financiers – there’s a man named “Paulson” (no relation to the Secretary of the Treasury) who, if my memory serves, made $10 billion in 2007 betting that the sub prime mortgages wouldn’t be paid off. So yes, people have pulled money out of the economy. Obviously, under the Bush tax cuts, they’re not putting it back in. They’re not using it to create companies and employ people. So yes, there are winners in this. In fact, Goldman Sachs in the summer of 2007 was wise enough to say to itself, “Hey! Betting that the sub primes would pay off is not a good bet.” And they reversed their betting position. They bet that they wouldn’t pay off. So Goldman Sachs came out of 2007 in relatively good shape. That to me makes a point: should we have an economy based on whether people make good or bad bets? Or should we have an economy where people built companies, create manufacturing interests, do inventions, advance American society, make it more productive? This economy is based on people sitting at their computers making bets – all day long. They call it credit default swaps, OTC derivatives, asset-backed securities, etc. etc., and that all makes it very complicated, but we are rewarding people for sitting at their computers and punching in bets. That’s not the way this economy is going to be built. India and China – with their focus on science, industry, and building real businesses – are going to eat our lunch unless the American public wakes up and puts and end to an economy that praises and makes heroes out of speculators.
TG: While we’re talking about deregulation and how that’s affected the economy there’s been such a revolving door in Washington between people in politics and industries of various sorts, there’s been a revolving door between government and the financial industry. Can you give us a few examples of that?
MG: I’ll give you a prime example. The deregulatory legislation went into effect – that essentially told Wall Street and hedge funds and banks, “Go ahead. Do these credit default swaps. Nobody’s going to regulate you. Do whatever you want. We won’t even keep track of what you’re doing.” There was a very strong argument that those products should have been regulated by the Commodity Futures Trading Commission – my old home. I was part of an effort that said, in 1998, when we’d already had twenty-two episodes of problems with regard to these products, that something must be done. While I was there, a very nice person who’s a lot of fun to be with, who’d been in the cattle industry in Mississippi and was a friend of the two Mississippi senators, was made a Commissioner of the CFTC. He didn’t know a lot about commodities. He was very open to telling people that. The first year he said absolutely nothing in meetings. But he ultimately rose to be the chair of the CFTC. He was very supportive of deregulating these instruments. When he left the CFTC, he became the president of Nymex, which is one of the most successful futures exchanges in the US. I believe last year he made several million dollars in bonuses. Nymex is about to be bought out. I’m sure he’ll make a very comfortable living from buying his stock in a sale. There is one example after another. The lesson that’s conveyed generally to people who go into some of these positions is, “Help Wall Street out and Wall Street will help you out in the end.” You’re sitting here talking to a dummy who didn’t take that advice! I’m just a poor professor at the University of Maryland School of Law! But the revolving door and the ability to revolve out the door is a tremendous temptation for those in government to be cheerleaders for deregulation as opposed to seriously trying to get to the bottom of the matter.