University of Maryland Francis King Carey School of Law

From the 2010 News Archive
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Prof. Greenberger Joins Soros, Warren to Discuss Restoration of Integrity to Financial Markets

Professor Michael Greenberger, JD, an internationally recognized expert in financial regulation, joined billionaire philanthropist George Soros and Congressional Oversight Panel Chair Elizabeth Warren on the "Restoring the Integrity of the U.S. Financial Markets" panel at the Hamptons Institute on July 16.

Greenberger teaches a class called "Futures, Options, and Derivatives" at the School of Law and he is a former director of the Division of Trading and Markets at the U.S. Commodity Futures Trading Commission (CFTC). Since 2008 Greenberger has testified a dozen times before congressional committees and regulatory agencies on issues related the economic meltdown. Most recently he testified at the Financial Crisis Inquiry Commission's (FCIC) June 30 "The Role of Derivatives in the Financial Crisis" hearing on Capitol Hill. Greenberger implored regulators, experts, and lawmakers to support tougher oversight and regulation of opaque derivatives markets that he says not only caused, but substantially aggravated, the financial crisis.

"What you have is a $600 trillion notional value market that is completely unregulated and dark; therefore regulators don't know what's happening out there, market observers don't know what's happening out there, and that led to a belief that we needed to rescue the entire market in the fall of 2008," Greenberger said during his opening statement.

Derivatives are complex financial instruments used to hedge risk. Traditional futures contracts, where one party agrees to buy or sell a certain commodity for a certain price at a set date in the future, are thought to be the earliest sustained derivatives transactions in America. Those trades happen on exchanges under the watchful eye of regulators - unlike the unregulated, over-the-counter (OTC) derivatives trades discussed at the hearing.

"In the case of derivatives, my fellow commissioners and I are seeing something we've seen many times in our investigation: enormous risk, reckless leverage, and early warning signs being ignored," said Phil Angelides, chairman of the FCIC.

Those early warning signs included the bankruptcy of Orange County, Calif., in 1994, the collapse of Long Term Capital Management in 1998, and the downfall of Enron in 2001, which was at the time the largest bankruptcy in U.S. history. In each case, derivatives deals gone bad were at the core. Leading up to the current crisis, large financial institutions bought and sold trillions of dollars worth of OTC derivative instruments linked to subprime mortgage securities, and those instruments would trigger a payout in the event of default. Greenberger noted that this particular type of OTC derivative, known as a credit default swap (CDS), fomented the mortgage crisis and subsequent credit and economic crisis by offering purported "insurance" to people investing in subprime securities. This insurance fueled excessive risk-taking, demand, and expansion of the subprime market. In October 2008, CDS made up an estimated $35 trillion to $65 trillion of the notional value of the unregulated OTC derivatives market.

Investors also purchased "naked" CDS on securities laced with subprime mortgages- akin to buying insurance on someone else's car. Greenberger said "naked" CDS turned Wall Street into a veritable casino operation because "naked" CDS are essentially a bet that non-creditworthy individuals won't pay their mortgages. One market expert estimates that three to four times as many "bets" were extant at the time of the meltdown than CDSs guaranteeing actual risk.

"The problem here is only in a small sense the mortgage default," said Greenberger.

The freefall of housing prices that began in 2007 left troubled homeowners unable to refinance and underwater in terms of equity, and rampant "betting" meant defaults reverberated throughout the entire economy.

"We would have been a lot better off Las Vegas had handled these side bets," Greenberger said.

Legislation passed in 2000 exempted the OTC derivatives market from capital adequacy requirements, among other disclosure and regulatory rules. Without a requirement to back up guarantees, the U.S. taxpayer became the lender of last resort when the housing market tanked and "too big to fail" financial institutions faced massive shortfalls. American International Group (AIG), for example, was able to underwrite nearly $80 billion in CDS with only $20 billion in reserves, a catastrophic gamble revealed only hours before the insurance giant was on the brink of collapse.

Michael Masters, a hedge fund manager on the panel, said derivates made AIG so interconnected with Wall Street that other large banks would have failed had the U.S. Treasury not stepped in with billions of dollars to bail it out.

But other panelists disagreed that derivates are largely to blame for the financial meltdown. Steven Kohlhagen, former professor of International Finance, University of California at Berkeley and a former Wall Street derivatives executive, said the federal government provided the spark.

"The cause of the financial crisis was quite simply the commitment by the United States government to bring homeownership to the next group of people who previously were not able to own their own homes," Kohlhagen said.

Kohlhagen went on to say that the crisis wasn't inevitable - it required "bubble enablers" like lending officers, lending institutions, the government's open-ended and poorly supervised subsidies to Fannie Mae and Freddie Mac, financial firms who created and sold assets they knew were of "dubious" value, ratings agencies, the Fed, and institutional investors.

Albert "Pete" Kyle, PhD, Charles E. Smith Chair Professor of Finance at the University of Maryland Robert H. Smith School of Business, also blamed the U.S. government's housing push, but said unscrupulous lending and banks that engaged in grossly irresponsible derivatives transactions were just as culpable.

The FCIC commissioners were divided in their opinion of each panelist's arguments, reflecting the commission's diverse background. Pointed questions came from Douglas Holtz-Eakin, director of the Congressional Budget Office from 2003-2005; Keith Hennessey, senior White House economic advisor to President George W. Bush; and Brooksley Born, former director of the U.S. Commodity Futures Trading Commission (CFTC). In the late 90s, Greenberger was the director of the Division of Trading and Markets at the CFTC and worked under Born when she led the CFTC's push for derivatives oversight and regulation.

Former Florida governor and U.S. Senator Bob Graham, also a commissioner, asked the panel if "peripheral derivatives," like speculative CDS "bets," hold any social value for the American economy. Greenberger said the economy did just fine before the 1990s, when arcane derivatives trading took off. Kohlhagen offered a retort: the same thing can be said for the Internet, and now it's an indispensible part of daily life. "The taxpayer didn't have to bail out the Internet," said Greenberger.

Click here to download a PDF of Professor Greenberger's testimony.

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