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|Clinton admits he missed the regulatory boat on financial derivatives|
Tuesday, April 20, 2010
WASHINGTON -- firstname.lastname@example.org
Nearly lost in the maelstrom of Goldman Sachs coverage was Bill Clinton's intriguing mea culpa.
The former U.S. president now acknowledges that he made a huge mistake in signing the Commodity Futures Modernization Act in 2000.
What the law did - and the U.S. Congress is now trying to fix - is to virtually exempt financial derivatives from meaningful regulation. We now know, of course, that a type of derivative know as a synthetic collateralized debt obligation is suddenly at the centre of the U.S. Securities and Exchange Commission's civil fraud case against Goldman.
Mr. Clinton says he got some bad advice about the derivatives from two high-profile sources - former treasury secretary Robert Rubin, and his successor Lawrence Summers. Mr. Rubin is a former Goldman Sachs co-chairman. Like Mr. Rubin, Mr. Summers, now director of U.S. President Barack Obama's White House Economic Council, was a champion of financial deregulation during the Clinton years.
"Their argument was that derivatives didn't need transparency because they were 'expensive and sophisticated and only a handful of people buy them and they don't need any extra protection," Mr. Clinton told Bloomberg News.
"The flaw in that argument was that, first of all, sometimes people with a lot of money make stupid decisions and make it without transparency."
And even though fewer than 1 per cent of investors are involved in derivatives, so much money was plowed into them that they helped drag down global financial markets when so many of these investments cratered, Mr. Clinton said.
Mr. Clinton is right. In 2000, synthetic CDOs became the hottest financial product going.
Unlike CDOs, which are similar to a bond mutual fund, synthetic CDOs don't contain any bonds. Instead, they are made up of credit default swaps, a form of insurance linked to the performance of a batch of underlying investments, typically bonds.
Synthetic CDOs quickly grabbed half or more of an already exploding CDO market earlier this decade.
The bonds remain with the issuer, such as a bank, but the risk of those loans is transferred elsewhere, and only becomes payable if there's a default.
The clear advantage is financial efficiency. A bank gets to redeploy its cash, and make even more loans - leverage piled on top of leverage. Think of it as exponentially increasing a bet at the blackjack table.
Synthetic CDOs are also attractive because they can be endlessly customized to suit investor and issuer needs, including capping losses, setting valuations or timing payments.
Critics have a dimmer view of what synthetic CDOs allowed. They hid from view both the extent and the ownership of risk. And they compounded the risk embedded in the system.
"Wall Street banks stuffed bad loans and bad loan packages into even more complex packages - including synthetic CDOs - to disguise problems and continue to earn bonuses," Janet Tavakoli, president of Tavakoli Structured Finance, argued yesterday in her Huffington Post blog.
"As everything started to fall apart, banks accelerated the scheme. They produced the most complex value-destroying deals in the shortest period of time."
Joseph Mason, an associate finance professor at Louisiana State University, said synthetic CDOs and other derivatives do have significant value, providing investors with critical and timely pricing information, which in turn makes markets more efficient.
The critical flaw, he said in an interview, is that many derivatives "divorce" voting and creditor interest from economic interest. That allows investors to bet against an underlying asset, which is part of the SEC's case against Goldman.
"It's a much deeper problem," Prof. Mason said. "But no one is talking about that in the regulatory reform we're dealing with [in Congress]."
Prof. Mason also faults regulators. The massive amounts of cash flooding into derivatives over the past decade should have been a warning to regulators of a potential problem.
"That's the main theme of this crisis: Regulation did not even bother to keep pace with innovation," he said.
For the last decade and a half, securitization was the fastest growing segment of the financial services industry, and a key source of funding for the same banks that enjoyed the government social safety net, according to Prof. Mason.
Prof. Mason likened the problem to crowd control at a major concert. When there's a flurry of activity in the audience, it probably makes sense for security to check it out.
Conveniently, for Mr. Clinton and his legacy, George W. Bush was the cop on the beat, starting in 2001.