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note: because important websites are frequently "here today but gone tomorrow", the following was archived from http://www.pbs.org/wgbh/pages/frontline/warning/etc/sitemap.html on October 30, 2009. This is NOT an attempt to divert readers from the aforementioned website. Indeed, the reader should only read this back-up copy if it cannot be found at the original author's site.

"The Warning"PBS/"FrontLine" - October, 2009

The hidden history of the Nation's worst financial crisis since the Great Depression

"We didn't truly know the dangers of the market because it was a 'dark' market," says Brooksley Born, the head of an obscure federal regulatory agency (the Commodity Futures Trading Commission [CFTC] ) who not only warned of the potential for economic meltdown in the late 1990s but also tried to convince the Country's key economic powerbrokers to take actions that could have helped avert the crisis.

"They were totally opposed to it," Born says. "That puzzled me. What was it that was in this market that had to be hidden?"

In "The Warning", veteran FRONTLINE producer Michael Kirk unearths the hidden history of the Nation's worst financial crisis since the Great Depression. At the center of it all, he finds Brooksley Born who speaks for the first time on television about her failed campaign to regulate the secretive, multitrillion-dollar derivatives market whose crash helped trigger the financial collapse in the fall of 2008.

"I didn't know Brooksley Born" says former SEC Chairman Arthur Levitt, a member of President Clinton's powerful Working Group on Financial Markets. "I was told that she was irascible, difficult, stubborn, unreasonable."

Levitt explains how the other principals of the Working Group -- former Fed Chairman Alan Greenspan and former Treasury Secretary Robert Rubin -- convinced him that Born's attempt to regulate the risky derivatives market could lead to financial turmoil. It was a conclusion that he now believes was "clearly a mistake."

Born's battle behind closed doors was epic, Kirk finds. The members of the President's Working Group vehemently opposed regulation. Especially when proposed by a Washington outsider like Born.

"I walk into Brooksley's office one day and the blood has drained from her face," says Michael Greenberger, a former top official at the CFTC who worked closely with Born. "She's hanging up the telephone and she says to me: 'That was [former Assistant Treasury Secretary] Larry Summers. He says 'You're going to cause the worst financial crisis since the end of World War II.' ... [He says he has] 13 bankers in his office who informed him of this. Stop, right away. No more.' "

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Greenspan, Rubin, and Summers ultimately prevailed on Congress to stop Born and limit future regulation of derivatives. "Born faced a formidable struggle pushing for regulation at a time when the stock market was booming," Kirk says. "Alan Greenspan was the maestro and both political parties in Washington were united in a belief that the markets would take care of themselves."

Now with many of the same men who shut down Born in key positions in the Obama administration, "The Warning" reveals the complicated politics that led to this crisis and what it may say about current attempts to prevent the next one.

"It will happen again if we don't take the appropriate steps," Born warns. "There will be significant financial downturns and disasters attributed to this regulatory gap over and over until we learn from experience."

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Timeline

1987 Jan. 1993 Feb. 1994For Reagan, a Banker made to order.

The new Fed chairman Alan Greenspan is a believer in Ayn Rand's philosophy (i.e., free-market capitalism means no regulations, no government intervention.

“He was a believer in Ayn Rand... Little bit curious ... because what is central banking?” -- Joseph Stiglitz

“Deregulation ... looked better at the time than it does to some people now.” -- Martin Feldstein

“Greenspan is a political animal. -- Paul Krugman

The New Clinton Economic Team

The country's best-known financier -- Robert Rubin -- joins forces with Greenspan. Both men believe the less regulation on the market, the better.

“The Clinton administration was very interesting because it was very divided. -- Joseph Stiglitz

“I remember sitting there thinking 'Now wait a minute. [The deficit] is going to set a lot of our plans back.' " -- Robert Reich

A Major Derivatives Scandal surfaces

Procter&Gamble sues Bankers Trust claiming the bank's derivatives deals have cost P&G millions. The lawsuit reveals what's really going on in the completely dark and unregulated derivatives market.

“Unfortunately for Bankers Trust, it's all caught on tape... ” --Michael Greenberger

“We were seeing some very dangerous things happening in that market.” -- Brooksley Born

[Announcer]: Tonight on FRONTLINE, long before the economic meltdown the story of one woman who tried to warn about the threat to the financial system.

[Manuel Roig-Franzia /The Washington Post]: She saw something that people either had not seen or refused to see. And she tried to sound the warning. Nobody listened.

[Rep. Spencer Bachus(R), Alabama]: What are you trying to protect?

[Brooksley Born /CFTC Chair 1996-99]: We're trying to protect the money of the American public.

[Arthur Levitt /SEC Chairman, 1993-2001]: I was told that she was irascible, difficult, stubborn, unreasonable.

[Narrator]: Before the toxic assets poisoned the economy, she warned of their danger.

[Ron Suskind, author of The Price of Loyalty]: And that made her the enemy of a very, very large number of people.

[Narrator]: She would fight an epic battle with one of the most powerful men in Washington.

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[David Wessel, author of In Fed We Trust]: He (Greenspan) was -- as George Bush put it at the time -- a "rock star".

[Joe Nocera / The New York Times]: It got pretty nasty pretty quickly.

[Michael Greenberger /CFTC Director 1997-99]: Greenspan turns to her, she turns to him. His face is red and he's clearly quite upset.

[Narrator]:A story from inside the highest levels of the Clinton administration.

[Timothy O'Brien /The New York Times]: They were all part of a very concerted effort to shut her up and to shut her down. And they did, in fact, shut her up and shut her down.

[Narrator]: Tonight on FRONTLINE, Alan Greenspan, Brooksley Born, and "The Warning".

[Jim Cramer, CNBC]: You need to get in the game!

[Narrator]: In 2005, economic cheerleaders dominated the airwaves.

[Jim Cramer]: I'm betting on Microsoft. That stock is not done going up, either!

[Narrator]: Times were good. Alan Greenspan ruled the economy.

[Jim Cramer]: When you can get a 3.7 percent yield with up side, that's a lot better than getting a … … … … …

[Narrator]: Washington's hands-off attitude toward Wall Street seemed to be paying off.

[Jim Cramer]: So now it's all systems go between now and … … … … … And I recommend a buy on it!

[Narrator]: It was time for a celebration.

[White House Announcer]: Ladies and gentlemen, the recipients of the Presidential Medal of Freedom.

[Pres. George W. Bush]: Alan Greenspan is one of the most admired and influential economists in our Nation's history.

[Narrator]: The Nation's highest civilian honor was bestowed on the man many called "The Wizard."

[Pres. George W. Bush]: always be known as one of the phenomenal … … … … …

[David Wessel]: More than one story was written about Alan Greenspan as "The Wizard", the Man behind the curtain the Wizard of Oz.

[Arthur Levitt]: Alan was a great wizard. No one understood what he said. But he said it in such a way that everybody bought it.

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[Rep. Maurice Hinchey(D), New York:] What's going to happen when all of this stimulation starts to decline?

[Arthur Levitt]: Everybody hung on his every word.

[Alan Greenspan /Federal Reserve Chairman]: Congressman, it depends on what is going on in the World generally.

[David Wessel:] "The Wizard", the man behind the curtain who mumbled in ways that ordinary people couldn't understand but who appeared to be controlling absolutely everything.

[Alan Greenspan]: Then we're going to get an exceptionally large amount of fiscal stimulus. Which we're not going to want.

[Arthur Levitt]: Very few people wanted to take him (Greenspan) on or challenge him because he knew so much more than they did. And if he didn't, he certainly appeared to.

[Pres. George W. Bush]: In 18 years as Fed chairman, he applied … … … … …

[Narrator]: Five presidents had watched Alan Greenspan work his magic. It started back in the Ford administration.

[Roger Lowenstein, author of When Genius Failed]: Alan Greenspan was a financial consultant who was hired by Gerry Ford, first to be head of his Council of Economic Advisers in the 1970s.

[Narrator]: But Alan Greenspan was not your stereotypical economist.

[Roger Lowenstein]: He was also very charming and a man about Washington.

[Narrator]: He played jazz clarinet and had made himself rich on Wall Street. And he had embraced an unusual political guru … … … … …

[Ayn Rand]: I'm challenging the moral code of altruism.

[Narrator]: the Libertarian philosopher Ayn Rand.

[Ayn Rand]: Everybody is enslaved to everybody.

[Joe Nocera /The New York Times]: Greenspan is a disciple [of Rand's]. She is the great champion of government as a destructive force that just gets in the way.

[Mike Wallace /"60 Minutes']: Can I ask you to capsulize your philosophy?

[Ayn Rand]: I am opposed to all forms of control. I am for an absolute laissez-faire, free, unregulated economy. Let me put it briefly. I am for the separation of State and Economics.

[Narrator]: Greenspan talked about Rand in his autobiography.

[Alan Greenspan in The Age of Turbulence]: "Ayn Rand became a stabilizing force in my life. It hadn't taken long for us to have a meeting of the minds mostly my mind meeting hers."

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[Narrator]: Rand stood in the Oval Office as her star pupil was sworn in.

[David Wessel]: Greenspan had a very clear ideology about regulation.

[Henry Kaufman /Dir., Lehman Brothers 1995-2008]: His philosophy was in the form of what was called Libertarianism. And that meant those who do well prosper, those who do poorly fail, and the market clears the transactions.

[Pres. Ronald Reagan]: "… that I will faithfully execute the office of president of the United States."

[Narrator]: It was a philosophy made to order for Ronald Reagan.

[Pres. Ronald Reagan]: Government is not the solution to our problem. Government is the problem.

[Narrator]: In 1987, Reagan made Greenspan the most powerful banker in the World -- the chairman of the Federal Reserve.

[Joseph Stiglitz /Sr. Clinton economic Adviser, 1993-97]: Greenspan was a believer in Ayn Rand, a believer in free market. A little bit curious for a central banker because what is central banking? It's a massive intervention in the market, setting interest rates.

[Narrator]: Greenspan worried about this contradiction in his autobiography.

[Alan Greenspan in The Age of Turbulence: "I knew I would have to pledge to uphold not only the Constitution but also the laws of the Land -- many of which I thought were wrong."]

[Pres. Ronald Reagan]: "And now the vice president will swear Alan Greenspan in as the 13th chairman of the Federal Reserve."

[Narrator]: He swore the oath and took the job.

[Alan Greenspan in The Age of Turbulence]: "I had long since decided to engage in efforts to advance free-market capitalism as an insider rather than as a critical pamphleteer."]

[David Wessel]: He understood that there were laws he had to enforce that he personally would not have passed. But he intended to do as little as he could on regulation. And he proceeded to do just that.

[Narrator]: And by the time Bill Clinton took the White House, the anti-government rhetoric had become so fashionable that even some Democrats embraced it.

[David Wessel]: Ronald Reagan had won. Government was seen as the problem. And even though Bill Clinton was someone who believed in government and wanted to use it, he was kind of forced into that Reagan-esque ideology because that was what people wanted to hear.

[Narrator]: From the beginning, Clinton aimed to reassure powerful forces on Wall Street and he did so with a key appointment.

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[Pres. Bill Clinton]: I have asked Robert Rubin to serve as assistant to the president for economic policy.

[Joe Nocera]: Rubin is the best known financier in the Country at that point because he had run the legendary Goldman Sachs.

[Timothy O'Brien]: Bob Rubin was Bill Clinton's emissary to Wall Street. Clinton placed great trust in Bob Rubin and Rubin's view of financial markets and financial regulation.

[David Wessel]: He had an enormous amount of credibility because he was a business success. And Democratic administrations always seem to worship people who can excel at business.

[Narrator]: At the White House and as Treasury secretary, Rubin found an unlikely ally. Clinton had asked Alan Greenspan to stay on.

[Timothy O'Brien]: Bob Rubin and Alan Greenspan were very much in lockstep. They had very similar views on Wall Street. It boiled down to the less regulation, the better.

[Narrator]: And Rubin populated the Clinton administration with a network of free market true believers.

[Joe Nocera]: It wasn't just Rubin and Greenspan who were these free market acolytes. That thinking pervaded the Treasury and the White House.

[Narrator]: Among Rubin's acolytes, 35-year-old Timothy Geithner and Rubin's top deputy -- the outspoken Harvard economist Larry Summers.

[Roger Lowenstein]: Summers was tough. Summers is very blunt-spoken and doesn't suffer fools lightly -- or anyone else -- as the saying goes.

[Timothy O'Brien]: Bob Rubin is not a guy who likes confrontation. He's confrontation-averse. But he understands that you need someone in there who can swing a heavy axe. And that person was Larry Summers. He was the "enforcer".

[Narrator]: Together, Greenspan, Rubin, and Summers formed their own pro-business, anti-regulation support group.

[Ron Suskind]: They're the committee to save the World according to the Time magazine cover. These are the people that we turned to at that moment who together -- all three in a way -- who say "Trust Us."

[Joe Nocera]: They seemed to have things under control. You know, the world trusted Rubin and Greenspan so why wouldn't Clinton, you know? And the market was doing great and the Country seemed to be doing great.

[Newscaster]: Big day on Wall Street, as stock prices return to territory not seen since December.

[Newscaster]: NASDAQ joining the party on Wall Street today, posting a triple-digit gain, along with

[Newscaster]: Stock trading at five times its7

[Newscaster]: the active volume, 55 million shares changing hands

[Narrator]: These were the euphoric go-go '90s.

[Timothy O'Brien]: Well, you know, the mid- to the late-1990s were a very ripe boom period. It was the most robust portion of the tech boom.

[Newscaster]: Internet fever has not subsided.

[Newscaster]: On the money tonight, Internet fever again.

[Newscaster]: EBay up 700 percent since September.

[Timothy O'Brien]: The financial markets were zooming.

[Newscaster]: Priceline.com is the latest beneficiary of the Internet stock craze.

[Joe Nocera]: The market was rocking and rolling.

[Newscaster]: Shares of the Web technology company soared more than 350 percent

[Newscaster]: The Dow Jones industrial average gained 91 points today

[Newscaster]: $300 a share!

[Newscaster]: Santa Claus arrives early on Wall Street.

[Narrator]: But in Washington, there was one agency that looked at the bull market with some skepticism. Buried deep in the bureaucracy -- the Commodities Futures Trading commission (CFTC).

[Daniel Waldman /CFTC General Counsel 1996-'99]: It was a small fish in an otherwise a pretty big pond. It was always viewed as kind of a sleepy, small, not terribly significant agency.

[Narrator]: The agency was authorized to regulate agriculture futures and to oversee arcane, complex financial instruments known as "derivatives".

[Ron Suskind]: You know, they're one of these little afterthought agencies that kind of get in the way of the big guys.

[Narrator]: The CFTC started "getting in the way" in 1996 when a new chairperson -- Brooksley Born -- took over.

[Brooksley Born /CFTC Chair 1996-99]: My law practice was in the derivatives area. I'd practiced derivatives law for more than 20 years.

[Joe Nocera]: Brooksley Born is a long-time securities lawyer. She has a stellar reputation. She's been "around the block". She knows her stuff.

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[Narrator]: Born was 55 and a veteran of the gender wars that had influenced many women of her age group. In Born's case, the struggle had started early. Born went to Stanford in the early 1960s. Most women in her class got married. Brooksley went to law school.

[Nancy Duff Campbell /Washington Attorney]: There were very few women in law school at the time. This was during the Vietnam War and a lot of men in the class saying: "What are you doing here? You're taking the place of somebody -- a man who could be here and not have to go to the war." The way she approached this was "Well, I've got to show them I can do it."

[Narrator]: She did graduate top of her class and the first female president of "The Stanford Law Review".

[Manuel Roig-Franzia]: You would think that this would be a moment of triumph for Brooksley Born. Instead, she gets a phone call from one of the deans. And he says: "Brooksley, I just want to let you know that the faculty stands ready to step in if you're not able to pull this off." It goes on like that -- on and on and on -- at each step of Brooksley Born's life and career.

[Narrator]: In Washington, she became a partner in a prestigious law firm; built an International reputation; and formed alliances with other powerful female attorneys including one who happened to be the wife of Arkansas's governor.

[Michael Greenberger /CFTC Director, 1997-99]: She had developed a very close relationship with Hillary Clinton when Hillary was a very prominent lawyer in Little Rock, Arkansas.

[Narrator]: And then Bill Clinton won the presidency.

[Manuel Roig-Franzia]: Born found herself invited down to Arkansas during the transition for a meeting with him to discuss possibly being the Attorney General of the United States.

[Nancy Duff Campbell:] She's very self-effacing. You know, she's flattered. But she's going to see if it happens.

[Newscaster]: Week seven of the Clinton transition. NBC's Andrea Mitchell tonight.

[Newscaster]: For Attorney General, Clinton is considering Washington lawyer Brooksley Born. But he may have … … … … …

[Michael Greenberger]: Brooksley went in for an interview with Clinton. The story that comes back was that Clinton found her boring and that she was it never went anywhere.

[Manuel Roig-Franzia]: It didn't happen. Janet Reno was chosen.

[Narrator]: And that's how Brooksley Born ended up running the obscure CFTC.

[Michael Greenberger]: I think to some extent that you could view this as a "consolation prize". To the general world, people who knew Brooksley, the circle she traveled, the American Bar Association, the DC Bar, and all the prestigious boards she served on, people were probably scratching their heads.

[Narrator]: An experienced financial litigator who'd seen the worst of the markets, Born was a believer in government regulation. Given the political climate in Washington at the time, clashes with

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Greenspan, Rubin, and Summers were inevitable. Almost right away, she had one. It began after she received an invitation to lunch at the Federal Reserve with chairman Greenspan himself.

[Manuel Roig-Franzia]: How could you not have a little bit of butterflies in your stomach when you're going to see Alan Greenspan at that moment in time?

[Narrator]: It didn't take long for Born to learn that she and the chairman were not going to see "eye-to-eye".

[Joe Nocera]: He said something to the effect that: "Well Brooksley, we're never going to agree on fraud." And she said: "Well, what do you mean?" And he said: "`You probably think there should be rules against it." And she said: "Well, yes I do." He said, you know: "I think the market will figure it out and take care of the fraudsters."

[Interviewer]: The Alan Greenspan lunch did it actually happen? Where he says … … … … …

[Brooksley Born]: I'm not going to talk about it. I'm not going to talk about it on camera.

[Narrator]: Born is reluctant to speak about her meetings with Greenspan or others in the Clinton administration. Greenspan refused to speak to FRONTLINE at all. But Born's advisers did.

[Michael Greenberger]: Greenspan didn't believe that fraud was something that needed to be enforced and he assumed she probably did. And of course, she did. I've never met a financial regulator who didn't feel that fraud was part of their mission.

[Manuel Roig-Franzia]: And this is an absolute stunner for the new head of this tiny agency who is charged with making sure people don't commit fraud.

[Nancy Duff Campbell]: Well, I think she was taken aback about how far he would go towards deregulation. That even the notion that we should police fraudulent activity he didn't think was something that was a given.

[Michael Greenberger]: That was her introduction to Alan Greenspan.

[Narrator]: The clash with Greenspan didn't intimidate Born. She was determined that her agency would investigate fraud at the first opportunity. One area that caught her attention was a new and highly lucrative market -- Over-The-Counter Derivatives.

[Joe Nocera]: She starts to realize that there's this whole world out there of what are called "over-the-counter derivatives" that are essentially unregulated. It's not even that they're unregulated -- it's that the government doesn't even know what's going on.

[Brooksley Born]: My staff began to say how BIG this was and how little information they had about it.

[Narrator]: On Wall Street, they described it as a "black box" -- i.e., only the parties involved in a deal knew what was happening.

[Kelly Holland /BusinessWeek 1992-99]: The derivatives market was a market that was not well understood; was growing rapidly; and that had a few really smart, aggressive innovative players.

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[Narrator]: Derivatives, swaps, basically bets between companies and banks, laying off risk.

[Timothy O'Brien]: Derivatives, in essence, are insurance policies that various players on Wall Street enter into to protect themselves from unforeseen calamities.

[Narrator]: It was a $27 trillion-market happening out-of-sight inside a black box.

[Brooksley Born]: We didn't truly know the dangers in the market because it was a "dark market". There was no transparency.

[Kelly Holland]: The conditions were very favorable for things to go wrong.

[Narrator]: As Born's investigators learned, there was also plenty of room for old-fashioned fraud.

[Michael Greenberger]: There's this major scandal at Bankers Trust where they have taken two of their customers -- Procter&Gamble and Gibson Greeting Cards -- "to the cleaners" with these complex over-the-counter derivative products.

[Newscaster]: Fraudulent dealings in derivatives sold by Bankers Trust.

[Newscaster]: Procter&Gamble claim they've lost millions of dollars from derivative deals arranges by Bankers Trust.

[Narrator]: In 1993, Bankers Trust -- one of the largest banks in the Country at the time -- had sold derivatives to Procter & Gamble.

[Joe Nocera]: Procter&Gamble sued Bankers Trust claiming that they had been sold products that they didn't really understand and that blew up in their face.

[Narrator]: The lawsuit set the stage for a stunning revelation. Bankers Trust employees took advantage of the fact that derivatives were too complicated to understand.

[Timothy O'Brien]: It opened a window onto what was really going on in the derivatives market.

[Narrator]: As part of the case, Procter&Gamble discovered secret audiotape recordings of telephone calls among Bankers Trust brokers.

[Kelly Holland]: There was one employee who described the business as a "wet dream". A Bankers Trust employee said: "We set them up."

[Timothy O'Brien]: They had taped phone calls from people inside Bankers Trust who were sort of chuckling, saying: "Ha, ha! These idiots really think that this is in their best interests but -- ha, ha! -- it's not. We're probably going to end up cleaning their clocks on these contracts."

[Narrator]: It had all happened in secret. Even this blatant scam might never have been discovered by the Government.

[Brooksley Born]: The only way the CFTC found out about the Bankers Trust fraud was because Procter&Gamble and others filed suit.

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[Narrator]: Looking inside Wall Street's black box was impossible for Born. Or indeed any other government regulator.

[Timothy O'Brien]: They're unregulated. The contracts aren't traded on exchanges. They're entered into between private parties.

[Brooksley Born]: There was no record-keeping requirement imposed on participants in the market. There was no reporting. We had no information.

[Adam Davidson /Planet Money, NPR]: There's no way, really, for the Government or anyone else to know how many of these are out there; know how big a market it is; and know who owns them and who owes who money because it's just a bunch of contracts in file cabinets in the lawyers' offices of banks and hedge funds all over the World.

[Narrator]: And that's what frightened Born more than anything. Trillions of dollars and the biggest banks in the Country operating in secret. If something went terribly wrong, the high-stakes derivatives market could take down the entire financial system.

[Michael Greenberger]: And that's what everybody's worried about. You have one big institution that fails. It can't pay its obligations. It forces somebody else into dangerous territory who can't pay their obligations and pretty soon, it's a falling domino effect through the Economy.

[Narrator]: As the market grew and morphed, Born felt her agency would have to get involved. But that would mean confronting Greenspan, Rubin, and Summers.

[Michael Greenberger]: She used to say she would lay awake at night turning in her bed because she could see the crises coming down the road building-and-building.

[Newscaster]: Federal Reserve chairman Alan Greenspan told Congress today that the economy is the best he's ever seen.

[Narrator]: By spring of 1998, the idea of tougher regulation seemed out-of-step with all the good news.

[Alan Greenspan /Federal Reserve Chairman]: Current economic performance is as impressive as any I have witnessed in my near half-century.

[Newscaster]: Those Internet stocks continue their meteoric rise.

[Newscaster]: Investors are hoping Alan Greenspan will give them another boost by lowering interest rates yet again.

[Roger Lowenstein /author of When Genius Failed]: You have to remember the context. Companies are going public and doubling and doubling every week of the year.

[Newscaster]: If you thought the Internet bubble was about to burst, think again.

[Roger Lowenstein]: Some weeks, it was happening every day. And you know, the idea of worrying about derivatives was just, you know, so-so 20th Century.

[David Wessel /The Wall Street Journal]: We were on a path towards "Wow! Markets can do great things." Communism was dead. Markets, capitalism was invincible.

12

[Narrator]: But at the Treasury, things were about to change. The carefully-calibrated inner tranquility was being disturbed by a small tremor. It quickly made its way up to Robert Rubin. Brooksley Born was contemplating the regulation of OTC derivatives.

[Joe Nocera]: The pushback is visceral and immediate. And that's one of the striking things about this.

[Narrator]: This was a job for "the enforcer" -- Larry Summers.

[Michael Greenberger]: I walk into Brooksley's office one day and the blood has drained from her face. She's hanging up the telephone. She says to me: "That was Larry Summers."

[Ron Suskind]: Larry basically reads her the "riot act". He more-or-less tells her, my understanding, is that: "You don't get it!"

[Michael Greenberger]: He says: "You're going to cause the worst financial crisis since the end of World War II," that he has, my memory is, 13 bankers in his office who informed him of this. "Stop right away! No more!"

[Narrator]: In Washington, they say, the financial sector has five lobbyists for every congressman.

[Timothy O'Brien]: Brooksley Born is stepping into the maw of the most well-oiled and highly-financed lobby in the history of Washington, D.C. It's the financial lobby.

[Roger Lowenstein]: Bankers just fall over themselves calling Summers and Rubin and Greenspan and everybody saying: "Get this lady off our backs."

[Narrator]: But the harder they pushed, the more interested Born became.

[Brooksley Born]: They were totally opposed to it. That puzzled me. You know, what was it that was in this market that had to be hidden? Why did it have to be a completely 'dark' market? So it made me very suspicious and troubled.

[Narrator]: Born's agency was legally independent. She reported to the President. Rubin had no authority over her. To stop her, he would call upon his allies who sat with him on a secretive council known as the "President's Working Group."

[Timothy O'Brien]: The President's Working Group was the most influential White House body on financial policy.

[Michael Greenberger]: It was called at the discretion of the Secretary of the Treasury.

[Timothy O'Brien]: It was a committee hand-picked by Bob Rubin and it was a committee that he steered.

[Narrator]: Larry Summers attended. So did Alan Greenspan and the chairman of the SEC -- Arthur Levitt.

[Arthur Levitt /SEC Chairman 1993-2001]: Alan and Bob and I had known one another and away from government. I think we all liked one another and respected one another.

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[Narrator]: By executive order, the head of the CFTC also attended the meetings.

[Arthur Levitt]: I didn't know Brooksley Born. I was told that she was irascible, difficult, stubborn, unreasonable.

[David Wessel]: Rubin, Summers, and Greenspan had a great deal of faith in their own intellects. And I think that they were not welcoming of somebody who looked at the World different and was kind of abrasive.

[Nancy Duff Campbell]: You know, they were used to dealing mainly with men and with people they knew. And here was someone they didn't really know. They didn't know that much about her. And to boot, she was a woman. So you know, put it all together and you've got somebody that you can kind of flick off with the back of your hand. At least that's what they thought.

[Narrator]: As Rubin was quietly preparing the working group, Born was taking the first steps toward regulating OTC derivatives, designing a document known as a "concept release". In response, Rubin acted, calling an emergency meeting of the working group.

[Michael Greenberger]: We're driven there and we get out at the entrance of the Treasury, go up to the room. Everybody assembles. The Secretary walks in. The meeting is called to order. And the subject of the meeting was to discuss the "concept release". And the clear mission of it was to convince Brooksley that it shouldn't be issued.

[Joe Nocera]: What's amazing is that Rubin and Greenspan said: "No, no, no! You can't do that. We just can't have this!" And it got pretty nasty pretty quickly.

[Nancy Duff Campbell]: Those on the other side were saying: "Look! this deregulated market is part of what's brought us the boom times. And so we don't we can't we don't want to change that. You know, the market will take care of everything. We really don't need regulation of these and --in fact -- it would be counter-productive."

[Michael Greenberger]: Each of the principals in turn -- that is to say Rubin, Greenspan, and Levitt -- take their shot at telling Brooksley that she shouldn't do what she's doing.

[Joe Nocera]: Rubin says to her: "You don't have the legal authority to do this."

[Michael Greenberger]: And Brooksley said: "Well, that's interesting. That's the first time I've ever heard that. All my lawyers at the CFTC have assured me that we have the exclusive jurisdiction to do this."

[Roger Lowenstein]: Rubin was condescending toward her. He said he would get his lawyer in the department to help her "understand the laws better". Or something like that.

[Narrator]: SEC chairman Arthur Levitt had been personally lobbied to join the effort to shut Born down.

[Arthur Levitt]: This tight-knit group persuaded me that we really would face a situation of financial turmoil if we tried to undo these existing contracts.

[Narrator]: And then it was Alan Greenspan's turn.

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[Michael Greenberger]: I happened to be sitting behind Brooksley and behind Greenspan. They're sitting next to each other. Greenspan turns to her, she turns to him. His face is red and he's clearly quite upset.

[Michael Greenberger]: He was very adamant that this was a serious, serious mistake. That it would cause untold damages to the financial services market and that she should stop and not do this. That it was unwise and would cause tremendous damage.

[Arthur Levitt]: In a group of this kind, there will be a disparity in power. It would take an extraordinarily outspoken, knowledgeable, pugnacious person to fight the losing battle against the titans who led that group.

[Timothy O'Brien]: It's the education of Brooksley Born. They decided that "Hey, she's not playing ball. We're going to teach her a lesson. And we're going to get this thing killed because we don't want it to happen."

[Narrator]: But two weeks later, Born told her staff to publish the "concept release".

[Ron Suskind]: That creates an earthquake. You're talking foundation of the building. And she is literally in the crossfire of an amazing number of bullets.

[Narrator]: The response of the working group was immediate and unprecedented.

[Michael Greenberger]: By the afternoon, Rubin, Greenspan, Levitt put out a statement saying: "This is a very bad thing and Congress should act with all deliberate speed to block it."

"We have grave concerns about this action and its possible consequences. We are prepared to pursue, as appropriate, legislation that would provide greater certainty concerning the legal status of OTC derivatives."

[Timothy O'Brien]: The powers-that-be in Washington put out the word to the media. And they put out the word to Capital Hill that her views were not to be trusted, that they were not to be taken seriously; that she was running a podunk agency; that this was a power grab; and she didn't have a clear understanding of the products that she was going to regulate and shouldn't be entrusted with that kind of power and it would be a great mistake if she were.

[Sen. Richard Lugar(R-IN) /Chairman]: This hearing of the Senate Agriculture Committee is now called to order.

[Narrator]: Only Congress had the legal authority to stop Born. Rubin, Greenspan, Summers, and Levitt lobbied hard.

[Sen. Richard Lugar]: Today we will receive testimony on Over-The-Counter Derivatives.

[Narrator]: Hearings were held almost immediately in both the House and the Senate.

[Rep. Jim Leach (R-Iowa 1977-2007)]: Brooksley is a lady and the men were gentlemen. But the feelings were quite intense. This was an enormous embarrassment to the Executive branch because they couldn't coordinate with each other.

[Joe Nocera]: There are a ridiculous number of congressional hearings.15

[Congressman]: It is essential that the Government not create uncertainty.

[Congressman]: CFTC wants to come into somebody else's yard here.

[Joe Nocera]: She just gets pummeled on Capital Hill.

[Sen. Phil Gramm (R-Texas 1975-2002)]: I see no evidence whatsoever to suggest that this is a troubled market, that fraud is rampant in this market.

[Larry Summers /Dep. Treasury Secretary]: The release has cast a shadow of regulatory uncertainty over a thriving market.

[Arthur Levitt]: The CFTC's action has and will bring, I believe, significant disruption to this important global market.

[Alan Greenspan]: Regulation that serves no useful purpose hinders the efficiency of markets to enlarge

[Joe Nocera]: All the regulators there testifying and, you know, all of them say: "This is a bad idea." "This is a bad idea." "This is a bad idea." "This is a bad idea.' Then she says: "This is a good idea". And the senators and congressmen just, you know, beat her over the head!

[Sen. Phil Gramm]: I feel very strongly that we should not have one agency innovate in this area and in doing so create very substantial financial problems.

[David Wessel]: 90 percent of the members of Congress couldn't have told you what a "derivative" was. So all they knew was that these guys on Wall Street -- some of whom make big campaign contributions and many of whom "seem" very smart -- say: "If we do this, it'll screw up the Economy."

[Rep. Spencer Bachus]: My question again is what are you trying to protect?

[Brooksley Born]: We're trying to protect the money of the American public. Which is at risk in these markets.

[Narrator]: That summer of 1998, Born testified four times before hostile Congressional committees.

[Brooksley Born]: They were hearing from very respectable sources that there was no problem and they chose to rely on those people. And I think that was understandable. I think it was unfortunate. But I think it was very understandable.

[Sen. Richard Lugar (R-IN)]: I thank each one of you for coming and for your testimony.

[Brooksley Born]: Thank you, Mr. Chairman.

[David Wessel]: The system wasn't set up to allow somebody like Brooksley Born to have a real impact.

[Jim Leach]: She was running against the tide of very powerful forces and powerful forces that were doing exceptionally well.

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[Narrator]: As Congress headed for the summer recess, it seemed likely they would not heed Born's warning.

[Michael Greenberger]: She had no support anywhere.

[Roger Lowenstein]: She wasn't a member. She had no political capital. She had no chance.

[6 weeks later...]

[Narrator]: Then Born's warning became a prophecy.

[Gary Gensler /Asst. Secy., Treasury, 1997-99]: I was at home and I got a call -- as I would often get a call -- from the Treasury operator. It was Secretary Rubin on a Saturday. And the Secretary of the Treasury wants to have a conversation with me about this hedge fund that apparently was about to go under.

[Narrator]: The hedge fund Long Term Capital Management was melting down. A quiet panic had begun. It looked exactly like what Brooksley Born had been warning about. Known on the Street as LTCM, it was the trillion-dollar favorite of "in-the-know" investors.

[Timothy O'Brien]: LTCM's a hedge fund. It's run by John Meriwether, ex-Salomon Brothers. He's considered one of the great geniuses of the bond market. Tons of money flows his way from private investors who would like to make a killing via his smarts.

[Roger Lowenstein]: The firm also had the former vice-chairman of the Fed -- Alan Greenspan's number two.

[Narrator]: David Mullins and John Meriwether operated LTCM outside government regulations.

[Roger Lowenstein]: They were the personification or the embodiment of Alan Greenspan's credo. That credo was: "Markets get it right."

[Narrator]: LTCM invented complex mathematical formulas and used derivatives to place their bets.

[Ron Suskind]: These guys are the rock stars -- the Long Term Capital Management team. They're sort of rock stars for the math clubs of America.

[David Wessel]: LTCM is a case study in arrogance. A lot of really, really smart people who thought they had a foolproof money machine. A number of them were Nobel Prize winners.

[Narrator]: Neither the Government nor investors knew anything about how LTCM worked. It was a completely secret process.

[Michael Greenberger]: If you want to invest in Long Term Capital Management, you've got to walk into a conference room, abandon computers, abandon pencils, abandon yellow pads, no notes, and you're told: "There's a black box. Look at these returns -- 46 percent, 40 percent, 20 percent." People are fighting to get in, to invest. People are fighting lend money.

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[Narrator]: LTCM did business with 15 of Wall Street's biggest banks, leveraging $5 billion into more than $1 trillion in derivatives.

[Brooksley Born]: All these big banks hadn't done their homework. They didn't even know the extent of LTCM's exposures in the market or the fact that all of the other OTC derivatives dealers had been lending to them as well.

[Narrator]: Then trouble. LTCM's complicated computer models were failing … … … … …

[Newscaster]: In Russia, the financial markets were hit hard today.

[Narrator]: rocked by a financial crisis in Russia.

[Roger Lowenstein]: The firm had all sorts of models that said no matter what happened, based on history they couldn't lose more than $35 million a day.

[Newscaster]: In Russia today, a grave financial situation grew decidedly worse.

[Newscaster]: The effects of the Russia crisis were evident everywhere.

[Roger Lowenstein]: They started dropping $300 million, $400 million, $500 million every day.

[Narrator]: Word of a pending collapse spread. Many banks had invested in LTCM's derivatives believing they alone were in a deal. They weren't.

[Timothy O'Brien]: When LTCM started to get stressed and these guys said "I want to collect my collateral", they all discovered that a lot of other parties had the same claims on it.

[Narrator]: With Wall Street's banks in a panic, LTCM was perilously close to collapse. And that's when Washington first heard about the problem. The Secretary of the Treasury began to contact members of the President's Working Group.

[Brooksley Born]: I got a call from the Treasury Department. I thought that LTCM was exactly what I had been worried about. None of the regulators had known they were on the verge of collapse. Why? Because we didn't have any information about the market.

[Narrator]: That weekend, the members of the working group were told the entire American economy was hanging in the balance.

[Gary Gensler]: Long Term Capital Management had very large positions in the over-the-counter derivatives marketplace. And if it came down, the question is "How would that affect the American public? How would that reverberate through the system and affect everybody's livelihood in the Country?"

[Timothy O'Brien]: The fear is that if it goes down, it would present what they call a "systemic risk" -- something that could unwind the entire financial system.

[Narrator]: At the Treasury, all they could do was watch and wait.

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[Roger Lowenstein]: It was very scary. Credit markets around the World just shut down. There was a period of real panic. People were very, very frightened. These firms were worried about -- in some cases -- their future and -- in some cases -- their survival. It was a real bloodletting.

[Narrator]: After four days, the Fed acted. But not directly. The Wall Street banks were pressured to bail out LTCM themselves.

[Michael Greenberger]: The Government said: "It is our belief that your financial stability is in jeopardy. And the way to solve this problem is for you each to pony up $400 million and buy the fund, prevent it from collapsing, and try to work the thing out."

[Roger Lowenstein]: 14 banks agree to put a few hundred million each. About $3.5 billion total.

[Narrator]: It worked. The crisis passed. In Washington, a collective sigh of relief. And then a call to action.

[Rep. Jim Leach]: The Committee will come to order.

[Narrator]: Some in Congress began to clamor for regulation.

Rep. Jim Leach]: The United States Government is obligated to be on top of the issues.

[Rep. Richard Baker (R-Louisiana)]: When and how did the concept of market self-regulation fail us?

[Rep. Bernie Sanders (I-Vermont)]: Americans should be worried about the gambling of Wall Street elites.

[Rep. Paul Kanjorski (D-PA)]: That puts at risk every American. It puts at risk Democracy.

[Rep. Maurice Hinchey (D-NY): How many more failures do you think we'd have to have before some regulation in this area might be appropriate?

[Joseph Stiglitz /Sr. Clinton economic Adviser 1993-97]: There was a strong sense that we ought to do something about these derivatives. That they really were posing a risk to our national economy and to the global economy.

[Narrator]: But Alan Greenspan had no intention of yielding.

[Alan Greenspan]: October 1, 1998: I know of no set of supervisory action we can take that would prevent people from making dumb mistakes. I know of no piece of legislation that can be passed by the Congress which would require us to prevent them from making dumb mistakes.

[Brooksley Born]: Congress was told that this was an anomaly. That this was not indicative of dangers in the market.

[Alan Greenspan]: I think it's very important for us not to introduce regulation for regulation's sake.

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[Narrator]: In the end, Congress agreed with Alan Greenspan. There would be no new regulations of over-the-counter derivatives.

[Michael Greenberger]: So now this is an unregulated market, no transparency, no capital reserve requirements, no prohibition on fraud, no prohibition on manipulation, no regulation of intermediaries. All the fundamental templates that we learned from the Great Depression are needed to have markets function smoothly are gone.

[Narrator]: But within the next few weeks, Congress did decide to do something about Brooksley Born. They stopped her entirely.

[Timothy O'Brien]: Essentially, what you had was a very bald and brutal power play. They defenestrate her entire agency. They say "Because you haven't played ball, we are now declaring a regulatory freeze on anything you folks can do in this market. Forget it. You're done." And she was.

[Narrator]: Born resigned.

[Brooksley Born]: There was not anything effective that was going to happen in the over-the-counter derivatives area. And I felt as though because of that, I had done what I could to help protect the Public and there wasn't much left for me to do.

[Narrator]: With Born out of the way, the last two years of the Clinton administration were a heyday of deregulation. OTC derivatives were off limits. Banks were freed to make riskier investments. Wall Street was largely left to regulate itself.

[Joe Nocera]: Again-and-again during the Clinton administration, you see these examples of the top regulators basically saying "The market knows better than us. And we're going to let the market do it."

[Narrator]: By 2007, the OTC derivatives market had grown to $595 trillion. That's $595 trillion.

[Newscaster]: Stocks shot higher, giving the Dow its best day in almost … … … … …

[Narrator]: The hands-off approach seemed to be working. Wall Street had bet heavily on the real estate boom.

[Newscaster]: The economy expanded at a robust 4.3 percent annual rate.

[Narrator]: Those derivatives were at the heart of that strategy.

[Joe Nocera]: You have derivatives insuring derivatives which are based on derivatives. It's an almost an Alice in Wonderland kind of profitability.

[Timothy O'Brien]: What, in fact, you essentially had was a big creaking time bomb that needed some sort of event to disrupt all the assumptions everyone had.

[Newscaster]: The stock market dropped by hundreds of points … … … … …

[Newscaster]: Profits in the banking industry are plunging.

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[Newscaster]: The jobless rate in America has now soared to … … … … …

[Newscaster]: The Dow tumbled … … … … …

[Newscaster]: The time bomb exploded almost exactly 10 years after the collapse of LTCM.

[Newscaster]: Investors were shaken by Lehman's bankruptcy filing and what was essentially … … … … …

[Timothy O'Brien]: You had the most raw panic the economy and the financial markets had seen since the 1930s. It was ugly. It was broad-based. It was bringing huge institutions to their knees. And a lot of that was tied into derivatives.

[Michael Greenberger]: They're hidden like land mines in a battlefield and nobody wants to give money to anybody else because they don't know.

[Newscaster]: AIG plunging. At one point, they were down … … … … …

[Newscaster]: If AIG can't raise $20 billion, they'll have to announce bankruptcy tonight.

[Brooksley Born]: It was my worst nightmare coming true. Nobody really knew what was going on in the market. The toxic assets of many of our biggest banks are over-the-counter derivatives and caused the economic downturn that made us lose our savings, lose our jobs, lose our homes. It was very frightening.

[Joseph Stiglitz]: I think to understand the crisis, you have to understand that it had many, many factors that contributed to it. But it's absolutely clear to me that if we had restricted the Derivatives, some of the major problems would have been avoided.

[Timothy O'Brien]: Had Brooksley Born been enfranchised, had Brooksley Born been listened to, had Brooksley Born been made part of the process, would that have had a different ending for what subsequently happened in the Derivatives market? Certainly.

[Narrator]: In the aftermath, one former member of the "Working Group" has had a change of heart about Brooksley Born.

[Arthur Levitt]: I've come to know her as one of the most capable, dedicated, intelligent and committed public servants that I have ever come to know. I wish I knew her better in Washington. I could have done much better. I could have made a difference.

[Narrator]: And the others? Robert Rubin left government to join top management at CitiBank. The taxpayers have pledged more than $100 billion to keep Citi afloat. Rubin's former deputies -- Larry Summers and Timothy Geithner -- have become President Barack Obama's chief financial advisers.

Neither Rubin nor his former deputy Larry Summers would speak with FRONTLINE about what happened to Brooksley Born.

And Rubin's other top deputy -- Gary Gensler -- now holds Brooksley Born's former post at the CFTC. It still lacks authority to regulate OTC derivatives.

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Alan Greenspan retired from the Federal Reserve just before the crisis hit in 2006. Last year, he once again appeared before the Congress.

[Ron Suskind]: You see Greenspan at the hearing table after the collapse. You see a crushed man, really.

[Roger Lowenstein]: He said that the premise that you could trust the markets to regulate themselves was "misplaced".

[Rep. Henry Waxman (D-CA)]: October 23, 2008: You have been a staunch advocate for letting markets regulate themselves. And my question for you is simple. Were you wrong?

[Alan Greenspan]: Yes. I found a flaw. But I've been very distressed by that fact.

[Rep. Henry Waxman]: You found a flaw in the reality.

[Alan Greenspan]: Flaw flaw in the model that I perceived is the critical functioning structure that defines how the World works, so to speak.

[Rep. Henry Waxman]: In other words, you found that your view of the World --your ideology -- was not right.

[Alan Greenspan]: Precisely. No, that's precisely the reason I was shocked because I've been going for 40 years or more with very considerable evidence that it was working exceptionally well.

[Joseph Stiglitz]: After almost 3 decades of public service, he realizes that the economic philosophy that he had pushed so hard -- i.e., resisting regulation of derivatives -- he realized that there were some fundamental flaws in that whole philosophy.

[Joe Nocera]: It was a pretty incredible moment that after a lifetime of faith in a certain way the World worked that Greenspan would say: "I was wrong."

[Roger Lowenstein]: It struck me as someone admitting that the core belief that had animated -- you know -- basically a 20-year, 18-year career as Fed chief was wrong. It's stunning. But it doesn't undo the damage.

[Newscaster]: President Obama visits New York today to deliver a major address to Wall Street.

[Narrator]: Last month, the president spoke on Wall Street.

[Pres. Barack Obama]: We will not go back to the days of reckless behavior and unchecked excess that was at the heart of this crisis.

[Narrator]: Right now, he is deciding how hard to push to regulate the OTC derivative market.

[Pres. Barack Obama]: We've got to close the loopholes that were at the heart of the crisis. Where there were gaps in the rules, regulators lacked the authority to take action.

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[Narrator]: The President's point man -- Larry Summers -- now says he supports strong regulation of over-the counter derivatives and Treasury has released a proposal outlining some of the same ideas Born had 11 years ago. But the financial lobby is still against those ideas and is lobbying hard at the White House and in Congress. The new regulations are stalled.

[Joseph Stiglitz]: I was very hopeful that in the aftermath of the crisis, we could see what had gone wrong and say "Let's fix it!" But it may be that we are passing that critical moment. And in that case, the necessary reforms will be just much more difficult to come by.

[Narrator]: As for Brooksley Born, without new regulations she's offering another warning.

[Brooskley Born]: I think we will have continuing danger from these markets and that we will have repeats of the financial crisis. It may differ in details. But there will be significant financial downturns and disasters attributed to this regulatory gap over-and-over until we learn from experience.

INTERVIEWS

Joseph StiglitzCouncil of Economic Advisers (1993-1997)

(Winner of the 2001 Nobel Prize in Economics, Stiglitz was a member and then chairman of the Council of Economic Advisers (1993-1997) and senior vice-president and chief economist of the World Bank (1997-2000). This is the edited transcript of an interview conducted on July 28, 2009.)

Could you give me a sense of the economic, financial worldview that was happening in Washington and on Wall Street during the 1990s?

I was a member and then chairman of the Council of Economic Advisers in the Clinton administration from 1993 to 1997. Then I went to the World Bank as chief economist. And so we were very much involved in all of these debates on what was the right role of government.

The Clinton administration was very interesting because it was very divided. There were those like [then-Secretary of Labor] Bob Reich that wanted a very strong government role. There were those like [Treasury Secretaries] Bob Rubin and Larry Summers who were very much for deregulation and getting government out of interventions in the market. And I was somewhere in between these two schools.

I believed very strongly that the market has an important role to play. But I also knew that unfettered markets were a disaster and there had been a long history of problems of deregulation, liberalization, free banking leading to disaster. ...

Very soon after I came to Washington, we began having these debates. They took place both in the domestic and in the international arena. In the international arena, the key issue was capital market liberalization. Whether we should use our influence, our power, to force countries like Korea to liberalize its capital markets, to liberalize their financial markets, to open themselves up to derivatives.

Many of us thought that it was not the role of the government to make the World safe so that Goldman Sachs could sell derivatives in Korea. That, in fact, these derivatives were highly risky --

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particularly for countries that were not at a more sophisticated stage of development and that we should not be intervening in their economic policies. ...

And so that was one of the first major controversies that we had. It was both a controversy about the role of the U.S. in the International arena but also the role of government in financial markets in the liberalization agenda.

The next issue that came very much to the fore was the issue of repealed Glass-Steagall Act. While I was chairman of the Council of Economic Advisers, that didn't go through. It happened after I left. I opposed it very strongly. I thought there were good reasons why we had passed Glass-Steagall in the aftermath of the Great Depression. You look at the history and it was clear that the quarter century after World War II in which we had strong financial market regulations is that one quarter century in the world in which there was almost no financial crises, no banking crises. It was also the period of most rapid economic growth. And it was also the period in which the inequalities in our societies were being reduced. So it was very hard to say that these regulations had stifled economic growth.

Where was that impulse coming from?

Oh, it's very clear. The impulse was coming from the financial markets. You have to remember, the Secretary of Treasury [Rubin] had been the head of Goldman Sachs (the largest investment bank) and he went on to become one of the chief executives of Citibank (the largest commercial bank). Very clear that there were strong economic incentives for mergers.

But there were three questions that we raised. The first was "What are you going to do about the conflicts of interest?" The response they gave was "We'll create Chinese walls." But then I asked: "If you have the Chinese walls, why bring them together? Where are the economies of scope?" And in fact as we looked at it, I thought you could see lots of problems but very little benefits to the Economy as a whole.

Those fears of conflicts of interest -- those fears that the Chinese walls would be very low -- turned out to be the case and we saw that in the WorldCom, Enron scandals the beginning of this decade. ...

But there were two other problems. One of them is that by breaking down these barriers, we would wind up with larger financial institutions that would reduce competition, increase the risk of "too big to fail". Banks that are too big to fail have incentives to engage in excessive risk taking. And that's exactly what happened. The increase in the concentration in the banking system in the years after the repeal of Glass-Steagall has been enormous and we've seen the excessive risk taking which American taxpayers have had to pay hundreds of billions of dollars for.

And the third factor that I think was not fully appreciated at the time -- but clearly is evident since -- was that the culture of these two kinds of institutions is and ought to be very different. Investment banks take rich people's money and are exposed to undertake risk. Which is appropriate to those seeking high returns but can bear the high risk. ... The basic commercial banks are supposed to provide finance to small and medium-sized enterprises. They are an essential part of the lifeblood of an economy. That kind of banking is supposed to be boring; it's supposed to be conservative; it's supposed to do the job of assessing risk and making sure capital goes to where it's supposed to go. ...

When you put them together, unfortunately what happened is the high-stakes, high-return culture of the investment banks dominated. And so what happened is the commercial banks which had the security of deposit insurance, the backing of the U.S. government, in effect, dominated. And we wound

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up having to pay, as I said, hundreds of billions of dollars to rescue these commercial banks that engaged in excessive risk taking.

Otherwise our economy was going to melt down and evaporate?

That was the concern. Now I think we went too far in some of these cases. We could have had a better structured bank restructuring. We didn't have to bail out the bondholders and the shareholders to the extent that we did; that's clear.

But in a sense, that is part of that whole story because the big banks used their political influence to get deregulation. They used their political influence to stop initiatives for new regulations to restrict their excessive risk taking in derivatives. And, not surprisingly, they then used their political influence to get this massive unwarranted transfer of money from the American taxpayers to them. ...

Now, there's a third issue that we dealt with in this period and that was derivatives. It was just the beginning of the development of derivatives. We had many meetings, brought together all the regulators including the chairman of the Council of Economic Advisers which was not a regulator but is supposed to be a neutral observer of the whole economic system.

The consensus was that derivatives were a problem. The broad view of almost everybody in this group was that they were posing very great risk. Unfortunately, though, the dominant voice -- [then-Federal Reserve Board Chair Alan] Greenspan, people in the Treasury -- was that there's nothing we could do about it. That it was too risky to try to stop this risk. That the intervening in the market would be a cure that was worse than the disease.

And so, not only did we allow these derivatives to continue to grow but then also we actually restricted the regulators from doing anything about it. This was in the period after I had left the Council of Economic Advisers and was over at the World Bank. ...

It was interesting that in the global economic crisis of '97 and '98, the IMF [International Monetary Fund], the U.S. Treasury said hedge funds had nothing to do with this. They're too small; they couldn't have caused these kinds of problems. But then when Long-Term Capital Management [LTCM] had a problem, they said the failure of one firm -- one firm alone! -- could bring down the whole financial system. Whether they were right or not, what is clear is that there was a perception on the part of many that there was a great risk and the banks used their political influence to get a publicly-orchestrated but privately-financed bailout.

In the aftermath of that, there was a strong sense that we ought to do something about these derivatives. That they really were posing a risk to our national economy and to the global economy.

And what happened to that impulse?

The free-market advocates squelched it. There were too many people making money. ... The combination of the free-market ideology and the special interests was very powerful. ...

Backing up just a bit, you talked about the sort of bipolar nature of the economic advisers to President Clinton. ... Where was Clinton on the economy? Did he step back and let you guys sort it out? Or did he have a real position one way or the other?

I'm not really sure. I think that as -- you might call it a "New Democrat" -- he wanted to distance himself from the excessive intervention of the New Deal. The New Deal had labeled Democrats as

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people who intervened in the market and the New Democrats wanted to show that we were market-friendly. So in that sense, he was trying to distance himself from the past.

And to be fair, the financial markets, the economy had changed a great deal since the New Deal, since the Great Depression and we needed new regulations. We needed them in telecom; we needed them in many other areas. And in that sense, I was very receptive to these kinds of changes.

On the other hand, President Clinton did understand that there was a need for government. But I'm not sure he really understood exactly what those needs were. I think he was very open to these discussions.

In the end, he often remarked that he wished in the next life to be born as a bond trader. I think that reflected his view of where the political power lay and also to a large extent, let me say, the economic power. The political power obviously is campaign contributions and political influence in a whole variety of ways with Congress. The financial sector has 5 lobbyists per congressman and is one of the largest contributors to campaign finance. So clearly they are a big player in the politics.

But even in the economics when markets are unhappy, stock markets can go down and interest rates can go up. If you are the president emerging from a recession -- which we had in '91, '92 -- and you feel that recovery is not robust and you've been elected on a platform of jobs, jobs, jobs, it's the economy, stupid! You don't want to do anything to roil the economy. And if you were told by the financial wizards that doing such-and-such will roil it or doing such-and-such will calm it, you're going to pay some attention to that perspective.

So on that side are Rubin, Summers, and Greenspan. ... How formidable are they? ... Greenspan -- who is he? What does he represent in this period of time?

I think the major protagonists -- those who were pushing for this ideology, this liberalization, deregulation, not doing anything about the risk of derivatives -- I think that they were a mixture. Greenspan, remember, always said that he was a believer in Ayn Rand who is a believer in free market. Little bit curious for a central banker because what is central banking? It's a massive intervention in the market, setting interest rates. So to me, that kind of perspective -- to say "I believe in free markets but I'm going to accept the job at central banking" -- is a contradiction. You almost have to be schizophrenic.

The question is what should be the interventions in the market? And we know we want some regulation -- how far do we go? Over the years, there's been a well-developed theory about when markets fail. We have a long historical experience and lots of economic theory.

Interestingly, some of the economic theory that was developed in the last quarter century -- my own work talking about what happens when there is imperfect information which is, of course, at the centerpiece of financial markets -- explains that the reason that the invisible hand seems invisible so often is that it's not there. Markets are often not efficient. We can identify the nature of those failures -- not perfectly but we can -- and say "These are the instances in which we need government intervention."

And I think that many of these protagonists didn't really understand those basic economic ideas. They were wedded to, you might say, the outmoded ideas of free-market economics which assume perfect information, perfect competition, perfect markets, perfectly informed market participants, no exploitation -- all assumptions that are totally irrelevant to a complex modern economy.

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But it looked to them -- as at first the tech bubble and then the housing bubble grew with relatively little, from their point of view, Government intervention -- that in fact there was an invisible hand and it was all good and it was guiding us along, yes?

If they had thought about it for a minute, they would have realized that the visible hand of the Government had been there over-and-over again. Just think about what the banks had done abroad. They had repeatedly, repeatedly viewed bubbles, misallocated capital, and the government -- U.S. Treasury, IMF -- had repeatedly come and rescued them. We had the Latin America crisis at the beginning of the 1980s involving almost every Latin American country. We had the Mexican crisis in 1994-95. We had the Korean crisis, the Indonesian crisis, the Thai crisis in 1997. We then had the Russian crisis and the Brazilian crisis in 1998. We had the Argentina crisis. The list is long, involving hundreds of billions of dollars, again, in Government intervention.

So yes, the economy did work. But it was because the Government kept bailing it out. It kept bailing out the financial sector. So they made a fundamental misinterpretation. ...

Let's go back just a little bit. I know you've left in '97. There is this woman Brooksley Born who takes over at the CFTC [Commodity Futures Trading Commission] in '97. Did you know her? Had you ever heard of her before she came into this obscure little agency?

No. I had been familiar with the CFTC because it had dealt with a couple of other problems. There was the ING [Barings] problem with rogue trader Nick Leeson.

The little things, basically?

Well, that could have blown up. And as I say, I was involved in the LTCM crisis partly because of this incoherence between what the Treasury and IMF had said during the East Asia crisis and then what they then said just a year later. And it was clear that derivatives -- this complicated, speculative risk-taking -- was at the core of it and that what they had said was totally wrong in 1997.

When Born decides to at least do a "concept release" [i.e., a report released to the public outlining a proposed rule change] and begins to ask questions about it, many people say a sort of nuclear reaction takes place. Rubin, Greenspan, Summers, and [former SEC Chair Arthur] Levitt all jump in and say: "Absolutely not. This is a horrible idea. This is going to reduce the economy to something akin to what it was like just after World War II."

What was she trying to do from what you can tell? Why would it get that kind of a reaction?

The derivatives were a major source of revenues for a few big banks. And those who were making lots of money out of it obviously wanted to continue with the source of money.

You have to ask the question did the economy really grow so poorly in the decades before we invented derivatives? Answer: We did actually pretty well. We did better in that quarter century after World War II before we had derivatives than we've done since then.

You have to ask the question what are financial markets supposed to do? They're supposed to allocate capital; they're supposed to manage risk; they're supposed to do this all at low transaction costs.

In retrospect, we can see that our financial markets misallocated capital, mismanaged risk, created risk, and did it all at high transaction costs. It's very clear that they were involved in trying to maximize transaction costs. That's their revenues; that's their profits. Some of the innovations in risk management

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had the potential of enabling firms to undertake more risk than they otherwise would have by shifting the risk off to others and that would have facilitated the growth of the real sector of our economy.

On the other hand, these derivatives are instruments for gambling. Non-transparent, difficult to see what's going on. And in that case, they are increasing risk, diverting attention from the real functions of the financial markets and leading to poor performance of the economy.

Without regulation, you're going to wind up with the negative aspects of derivatives and not the positive aspects. And that's precisely what happened. So while they were a potential instrument for improving financial markets, if they are not used correctly they are a potential -- as somebody said -- weapon of mass financial destruction. And that's what they turned out to be.

The lack of transparency illustrated by AIG [American International Group] and what happened there -- we should understand that magnitude of the problem. When I was in the Clinton administration, we debated long hours over welfare reform, over dealing with some of our toxic-waste problems. There were so many things that we wanted to do but we couldn't do because we didn't have the money. The amounts of money that we were talking about were a few billions of dollars. President Bush vetoed the bill to provide health insurance for poor Americans saying we couldn't afford it. Again, talking about a few billions of dollars. And that was just a few months before we found $700 billion to bail out our banks. And of that, almost $200 billion went to AIG.

So we have to bear in mind when we're saying that these banks made a mistake, they made mistakes that cost us so much money that would have allowed us to do so many other things. We're not talking about nickel-and-diming -- we're talking about big dollars. These are not minor little mistakes -- these are Big, BIG mistakes. ...

Let me give you another example of the lack of transparency, so not transparent that the financial institutions themselves didn't know what was going on. And if they didn't know what was going on, how can ordinary investors know what's going on? How can the regulators know what's going on? How can we have a well-functioning financial system?

The financial institutions that were creating these derivatives, these gambles, they would bet this bank would go down. "I'll bet you so much, a couple billion dollars." And then they would change their mind and say, "No, no, let's cancel that bet." But rather than cancel the bet, the other party would make a bet going the other direction. So if I bet you $10 and you bet me $10, the net is zero.

So that's how you got these gross numbers that were in the trillions. They said "Don't worry; these net out." That's true except if one thing happens. If one of the two parties goes bankrupt. If A owes B and B owes A but A goes bankrupt, then A doesn't owe B but B still owes A. They don't net out.

If you ask them, they would have said: "Who could believe that any of them would go bankrupt? These are the biggest companies in the World -- AIG, the biggest insurance company in the World." But then you ask what were they betting? They were betting on the demise of each of these companies. That's what the market was. So they at the same time said it would never happen and yet the market was bets about that it did happen. Total schizophrenia. ...

So they created a system that was so non-transparent that each of the banks didn't really know their own balance sheets. What they knew is they didn't know and they knew that they couldn't know what a balance sheet of any other firm was.

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Financial markets are based on trust. That trust evaporated and our financial markets came to a collapse. And that is part of what has led to the economic crisis, the freefall from which we are now just recovering.

So why was the CFTC prevented from regulating?

I think there are 2-or-3 aspects of this. The first is obviously this ideology of free market economics -- i.e., don't interfere -- and that's a presumption.

That's Greenspan?

That's Greenspan and it's a lot of other people as well.

The second is very simple -- the special interests. Lobbyists, campaign contributions -- they were making money and they want to continue making money. It was generating fees. Interesting thing is that right now, one of the big debates is to what extent should these derivatives be traded on exchanges or over the counter. To what extent should they be standardized products rather than tailor-made? The fact is when they're traded on exchanges and are standardized products, there is strong competition and a lot of transparency. Competition and transparency drives profits down, drives down transaction costs. The banks don't want that because they make their money from transaction costs and they like lots of non-transparency. So that's what the battle is right now. ...

But the third point is financial markets have consistently tried to use fear to motivate, to get the rest of us to do what they want. ... It was fear that led to the hundreds of billions of dollars that were turned over to the financial markets in response to the crisis. And that was exactly the same tactic that they tried to use in the late -90s. They said "If you do this, the whole thing will collapse."

They used to say when I was in the Council of Economic Advisers that if you talk about the appropriate strategy for monetary policy, it will lead to turmoil in the markets and the whole economy will collapse. You know, fear over-and-over again. Greenspan said: "If you don't cut the deficit, the whole economy will collapse."

And yet a few years later, Greenspan supported the tax cuts that led to the soaring deficits. So they used fear as an instrument to get what they want. And unfortunately, people say these are the "wizards of finance" and they give deference to these so-called "wizards of finance". But they shouldn't.

Was Rubin especially susceptible and vulnerable to that argument? Was he a handmaiden,or was he a willing participant -- even leader -- in that movement?

This use of fear as a tactic I heard from almost all of the major participants in the market. From Rubin, from Greenspan, from Summers. I can't tell whether they really believed it or whether they found it a convenient argument. I don't know whether they really didn't understand economics, didn't have faith in the market.

I mean, that's the strange thing because if you think that the markets are really understanding of what's going on, they would be able to see through discussion. ... I actually had more confidence in the market than many of these market participants because I said: "Look, they're going to be able to make judgments about which of these statements make sense and which don't."

... Should Born have known what was inevitably going to happen to her and her ideas?

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I think that she was fulfilling her responsibility. When you take on these jobs, if you do it in a responsible way, you say the reason there's regulation is to prevent these kinds of abuses. And she believed that the force of argument would win. Maybe that was a little bit naive but after all, we had just had this approach to a global financial crisis -- at least in the eyes of many -- with the Long-Term Capital Management collapse. So you would have thought that this coming so close to a global financial crisis would say: "We have to do something about this. We can't just let things go on as they did before." ...

But instead what happened was Congress passed a moratorium that said her agency can never regulate. And by 2000, it passed the CFMA [Commodity Futures Modernization Act] which essentially says we're going to deregulate the world of derivatives. And it passed the repeal of Glass-Steagall, the Gramm-Leach-Bliley. So in response to LTCM and in response to her impulse, in fact we go completely the other way.

It's actually even more striking because economic theory had explained why it was that we need an important role of regulation. We had had a global financial crisis in '97, '98 where we saw the dangers that capital-market liberalization had brought upon the World. ...

... Where was our government at that moment?

Government inevitably is going to reflect the pressure of special interests. Particularly as elections get near. And remember, many of these people came from or were closely allied with financial markets. We have a problem of "revolving doors" -- i.e., people coming from the financial markets, going to government and going back to financial markets. Their mind-set is affected by financial markets; they see things through the lens of the financial markets. And so they don't have to be influenced. They are the financial markets in a sense. ... If we had had more people that, for instance, had suffered from the problems of predatory lending, there might have been less confidence that financial markets always work so well. ...

In the Fall after the meltdown, Alan Greenspan goes before the Congress and he does a sort of mea culpa. What did you make of that?

I think it was a moment of honesty. I think he had genuinely believed in self-regulation which I view as an oxymoron. Now as an economist, we realized that the whole notion of self-regulation was an absurdity because one of the reasons for regulation is what we call externalities. A failure in a bank or a failure of the financial system has an effect on everybody. And the bank is looking only at its direct cost and benefits -- not on the cost on the rest of our society. And it's those external effects that provide the motivation for government regulation. ...

He didn't admit to that problem. But what he did admit to is he thought that at least the bankers would have enough rationality that they would look after their self-interest; that they would not engage in excessive risk taking to the point that they would put their shareholders and bondholders in jeopardy. But to me, if you look at the incentive structures that were confronting the managers of these banks, they had incentive structures that encouraged excessive risk taking and shortsighted behavior. ...

Do you think it was hard for Greenspan to say that?

Yes, I do. Because it was so much part of his mind-set and his conviction. I think Greenspan was honestly doing what he thought was best for the economy for a long period of time. He was a public servant and we should never forget that. For 18 years he worked very hard night-and-day for what he thought was in the interest of the American people. And he did this, I think, with a particular mind-set

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and talking to a particular group of people that helped shape that mind-set with a particular set of beliefs. He could have gotten a lot more money if he had been in the private sector. So he really did sacrifice a great deal to pursue what he thought was in the public interest. ...

If Born would have succeeded, would things actually have been different? ...

I think to understand the crisis of 2007, 2008, 2009, you have to understand that it had many, many sources and many, many factors that contributed to it. The underlying recklessness of the banks, their perverse incentive structures, the fact that they were too big to fail encouraged them to engage in excessive risk taking; meant that if you had tied their hand in one direction, it's likely that they would have moved in another direction.

But it's absolutely clear to me that if we had restricted the derivatives, some of the major problems would have been avoided. Some of what it has cost American taxpayers, a great deal would have been avoided. I think there is a very high probability, for instance, that we would not have had to pay out the hundreds of billions of dollars that have gone to AIG, that much of the other financial turmoil we would have avoided. But we still would have had the problems of the mortgages. We still would have had the problems at rating agencies.

So I think it's too simplistic to say that if we had done this one thing, we would have avoided the crisis. ... I view her experience as a dramatic illustration of what was wrong with the system and the power of the financial markets to resist doing what should have been done. But they did it with predatory lending. They did it with mortgages. They did it in area-after-area. And it would have needed a comprehensive attack to stop that. ...

You write that once the credit crisis is behind us that we start charting a new direction which is starting now. This is a dangerous moment. What do you mean by that?

The challenge we have right now is are we going to create a financial system that actually does what a financial system is supposed to do? Provide credit to small- and medium-sized enterprise? Manage risk? Help homeowners manage the risk of owning their home? Provide capital to new enterprises, money to the venture capital firms? These basic core functions of the financial markets.

Our financial markets failed and they failed massively. Take even one simple idea: electronic payment mechanism. Modern technology allows for us to have an efficient electronic payment mechanism. It shouldn't be the case that when you go to a store and you want to pay with a debit card that that merchant has to pay 1 percent or more to the bank. It should cost a couple of pennies.

The financial market would like to go back to the World as it existed before 2007 because they did very well. But our financial markets were too big. They were garnering over a third of all corporate profits. What should be a means became an end in itself. And remarkably, it didn't even do what they were supposed to do.

So this is a dangerous moment because if we don't get it right, we are likely to wind up with an even more politically influential financial system. Banks that are even bigger, more too big to fail, too big to be financially resolved. And so the risk of another crisis some years down the line is going to be greater. The risk that our economy's performance will be weaker, the risk that there will be greater inequalities and a sense of injustice in our society will be higher.

So I think this is really a moment. I was very hopeful that in the aftermath of the crisis we could see what had gone wrong and say "Let's fix it." But it may be that we are passing that critical moment. ...

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Arthur LevittChair / Securities&Exchange Commission (1993-2001)

(As head of the Securities and Exchange Commission (1993-2001), Levitt opposed Brooksley Born's attempts to regulate derivatives. He's since had a change of heart. This is the edited transcript of an interview conducted on July 29, 2009.)

This film starts in the mid-90s. ... Help characterize [former Federal Reserve Board Chair] Alan Greenspan at that time. Who he was and what he represented in terms of the economic policies of the country.

Alan is a good friend and I knew him before I came to Washington and knew him well when he was there. We played golf and tennis together. We saw a good deal of one another.

He was probably the most highly respected and most revered person in the city at that time. He was more than an economist. He is a very broad-gauged individual with large numbers of friends and a tremendous following in Congress where people hung on every word -- most of which they didn't understand but because it was Alan, they thought it was great.

Now keep in mind I have a theory about these government jobs whether it be chairman of the Federal Reserve or head of the SEC [Securities and Exchange Commission] or the FTC [Federal Trade Commission] -- to some extent, the "Wizard of Oz" jobs. It's not the rules; it's not the regulations. It's what they say. It's the issues they stake out and how they come across.

Alan was a great "wizard". No one understood what he said. But he said it in such a way that everybody bought it. Everybody hung on every word. And he was a good enough politician that he had great respect on both sides of the aisle. Very few people wanted to take him on or challenge him because he knew so much more than they did. And if he didn't, he certainly appeared to.

In a nutshell, what was his economic philosophy?

It's been reported pretty broadly that Alan was a laissez-faire, Ayn Rand, free-market economist. I think that's simplistic. He was much more than that. He was thoughtful, careful, measured, not at all impulsive, very traditional and pretty set in his ways.

Robert Rubin -- help characterize him for me.

Bob was gracious, intelligent, outgoing, accessible, friendly, warm, extremely knowledgeable and balanced and a very superb listener.

His sway, his clout as Treasury secretary? What did he have? What did he bring to it? What did he advocate for and against?

He had the confidence of the President. You don't need to go much further than that to be an effective Treasury secretary. He not only had the President's confidence but he also had the respect and affection of the people that worked for him. He had a broad history of exposure to every policy-maker in Washington. Traditionally, there are tensions between various agencies, between the Fed and the SEC, between the Treasury and the Fed and the SEC and the Comptroller's Office.

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We'd known one another for any number of years so that the traditional tugs and pressures that ordinarily create less than efficient relationships between the agencies simply didn't happen here. Alan and Bob and I had known one another away from government. I think we all liked one another and respected one another.

I always hear about Rubin acolytes all throughout the government, [Secretary of the Treasury] Tim Geithner being one of the most notable now, [former Secretary and current Chair of the National Economic Council] Larry Summers as well. In what sense were they acolytes? What was the philosophy, the Rubin approach, if there was such a thing?

The Rubin approach was an open, friendly, participatory approach. When faced with a difficult issue, Rubin's style was typically to say: "You know, I don't really know much about this issue. What do you think?" That's pretty engaging. And he instantly won over the person who now felt that he knew more than Bob Rubin did. Bob knew a good deal about what he said he didn't know very much about. But in that way, he was able to draw out other people.

Help me with Summers. ... What was Larry's standing in all of this?

The book on Larry was that he was tough and officious and dictatorial and unreasonable. I never found that to be the case. I found him extremely intelligent, extremely willing to listen to reasoned ideas and very helpful to me personally and the SEC as an institution. Our funding was threatened at various times by the Congress and Larry was ready, willing, and able to defend us. I think he did a very good job and we worked extremely well together. ...

[Former Chair of the Commodity Futures Trading Commission] Brooksley Born.

Didn't know Brooksley Born. I was told about Brooksley Born. I was told that she was irascible, difficult, stubborn, unreasonable. I've come to know her as one of the most capable, dedicated, intelligent and committed public servants that I have ever come to know. I wish I knew her better in Washington. And I wish my view of her was more rounded by personal exposure. ...

In my life I've had so many occasions of finding my impressions were incorrect and revising them depending upon the circumstances, depending upon what stage of life I happen to be or what other factors were bearing on it. You've asked me about these people and I've come to know all of them reasonably well. I've got to say to you that I have just huge affection and admiration and trust in Brooksley Born.

Based on?

Based on seeing a good deal of her in recent months, in talking to her about what I regard to have been a bad judgment that I made during that period when she was urging the President's Working Group to allow her to regulate swaps. You tend to gain some perspective when you recognize that you might have made a mistake.

I've talked to people who say that what happened between CFTC and the President's Working Group -- and really Alan Greenspan -- was really a function of an intramural squabble between the SEC and CFTC. ... Was it? Was that the beginning of the struggle?

I think there was tension between the staffs of the SEC and the CFTC. That's historical and that goes for Treasury and the Comptroller's Offices. Always a certain amount of turf battle going on. No

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matter how well the leadership may go along, the staffs were constantly concerned that their leaders were caving in to the other agencies.

Brooksley really wanted to regulate a fairly bread&butter product, a swap. It's not the CDOs [collateralized debt obligations] and CLOs [collateralized loan obligations] and the toxic vehicles that we're talking about today. And whether we regulated them or not probably wouldn't much have changed where we are at today.

However, the argument made against doing this was that there are trillions of dollars of notional contracts out in the world today. To regulate these products now would throw them into question and create international financial turmoil.

Now you have to keep in mind that the President's Working Group is made up of maybe 20, 25 people. In my judgment, only 3 people really mattered in that group. The Secretary of the Treasury, the Chairman of the Fed, and the Chairman of the New York Fed. The rest of the group tended to follow the leadership of those all-powerful financial officers.

Now in this case, this tight-knit group persuaded me that we really would face a situation of financial turmoil if we tried to undo these existing contracts. My staff tended to agree.

I can't ever recall talking directly to Brooksley about this. And where I really missed a beat was in not saying: "Yeah, you're right. We would have thrown these contracts into total confusion. Let's grandfather them. But going forward, let's regulate them. And more importantly, trillions of dollars and no clearing facility? Let's mandate a clearing facility." And I didn't do that.

Why?

I just didn't. I got caught up in the argument and didn't think about this very obvious next step. So it was clearly a mistake. I certainly testified in Congress subsequent to that and was somewhat less accepting of what we had done. But I could have done much better. I could have made a difference.

There was a meeting April 21, 1998. She's there, you're there, Rubin is there, Summers is there, Greenspan is there. And Greenspan turns to her -- we've had people in the meeting tell us -- and really she's talking about doing this "concept release" [a report released to the public outlining a proposed rule change]. And Mr. Greenspan really lets her have it as apparently only he can do! Do you remember that?

I don't.

It's a substantial moment in her life where people say she kind of drained. But you have no memory of it?

No. Are you certain I was there?

People have told me you were there.

I really don't remember. ...

When the concept release is released May 7 now, a fairly unusual thing happens which is that Rubin, Levitt, and Greenspan publicly ask Congress to disavow the concept release -- or

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whatever she's trying to do -- and ask Congress to step in and act, give direction. Do you remember where that idea came from? Were you in a meeting where that happened?

I really don't. I don't know how much it had to do with the pending Gramm-Leach-Bliley legislation, whether it was part of that. I honestly don't know. ...

Did what she was proposing with the concept release ever really have a chance given the times, given the move toward Gramm-Leach-Bliley, all of that movement in that deregulation direction? Did she ever have a chance of stepping up and kind of swimming against the tide?

Probably not because of the power of the Secretary and the Chairman of the Fed. In the power structure of Washington, it would be very difficult on an issue of this kind -- with the Congress solidly backing those two officials -- for any agency head to have turned that around.

Did you understand the derivatives? Did you understand the swaps?

Yeah. There was nothing mysterious about swaps. Again, they are not the product that people look upon today as being so dangerous and complex and risky. Swaps were a very appropriate product used to help manage risk and add liquidity to our markets. If I had a magic wand and could ban all derivatives, I wouldn't wave that wand. I think properly used, derivatives are a very important financial tool. ...

How did you react when you heard about what was happening with LTCM [Long-Term Capital Management]?

I guess I wondered at the time whether the failure of LTCM would have resulted in some sort of economic meltdown. I've never been persuaded that that was necessarily the case. I've seen a number of times in the financial history of the Country where we've stepped in -- Drexel Burnham, Hadenstone and LTCM -- where I wondered would this have resulted in Armageddon? And you never know, of course. It's probably better to have been proactive than to roll the dice. But it was a big moment and my notice came from the chairman of the New York Fed, Bill McDonough. I certainly was supportive of the efforts to salvage that situation.

The President's Working Group tends to get together around moments like that, yes?

No, they tend to get together on a fairly regular basis. I'm not a great believer in the effectiveness of that body. The power differential is so significant that the head of a fairly small agency just doesn't have the status of the others.

Now I can't recall a single member of that group opposing the arguments against Brooksley Born. I can't remember anyone raising their hand and saying "Brooksley's right." Do you have any information to the contrary?

Absolutely not. She's the single voice.

Okay. Let's not lose sight of that.

And what does that say to you?

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It says to me that in a group of this kind, there will be a disparity in power. And it would take an extraordinarily outspoken, knowledgeable, pugnacious person to fight the losing battle against the titans who led that group.

CFTC itself as an agency or -- as I guess -- a commission or whatever it is --

It was a backwater commission in those days. ... At that point, it was an ill-funded, politically-controlled agency that was superseded by the SEC which had a longer tradition, greater funding and a much stronger following in Congress. I think that's changed and I think that's all to the good.

Even so, even if she had prevailed in the argument, how could that agency have ever regulated anything?

Oh, I think it could have.

Could?

Yes, absolutely.

How?

Just the way any agency regulates. They had an enforcement staff; they had people. They certainly could have put out a regulation that if it were passed could have been effective for that particular product. Which was the plain vanilla swap. But there was much more to it than that. ...

I say that the failures in our regulatory and oversight mechanism that brought us to where we are today were far more consequential than merely the decision not to regulate swaps. They were broad failures of oversight. And if I had to pinpoint any aspect of it -- it really had more to do than anything else -- it's campaign finance where literally for 20 years in Democratic and Republican administrations we had deregulatory Congresses. Of course, there were some exceptions. There were the [Rep.] John Dingells [D-Mich.] and the [Rep.] Ed Markeys [D-Mass.] and some others. And Sen. [Carl] Levin [D-Mich.] who were protectors of the SEC.

But by and large, certainly during my 8 years in Washington there wasn't a single pro-investor initiative that we brought before the commission that we didn't have tension from the Congress, opposition from the Congress, on behalf of constituents whose contributions and lobbying efforts didn't do the best they could to thwart our efforts to choke us for resources, to threaten us with irrelevancy. It was a constant, never-ending tension.

Now it's these same overseers who allowed a runaway period of exuberance, of lack of control, of permissiveness, of inadequate accounting standards, that when the WorldComs and Enrons hit, the very same people became latter-day Elmer Gantrys calling for regulations that were so costly and over the top that they made very little sense. That's been kind of the history of the country's regulatory status, that during normal times Congress doesn't want to rock the boat. When there's a scandal, when their constituents are out there bleeding in pain, Congress will then act and very often overreact.

When you talk about the constituency that paid for Congress, who is that?

Various business groups that cared about regulatory issues that were before a commission, the Congress, the CFTC. Accounting groups, major issue. Groups that were concerned with market

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structure -- these were the stock exchanges, the electronic marketplaces, the legal community that had clients that had very specific problems with the regulatory agencies.

Remember, both the CFTC and SEC were essentially investor protection agencies. And I think if you balance the interest that faced the Congress in normal times -- not when the Country faces an economic catastrophe but in normal times -- the clout of the business community, fueled by the Chamber of Commerce, the Business Roundtable, that is going to have a greater impact than consumer groups.

Now that's changed today. It's changed because we have a populist environment fueled by the worst economic crisis in the history of America and we're going to see a totally different dynamic with different problems. Our Congress tends to act only at a time of crisis. And heaven knows, we've gone through that and are going through that.

Yes, because even after LTCM --

Mild.

Mild by comparison. But everybody for a little while was saying "Hey, let's do something about this." But that impulse passed.

It passed quickly. And indeed, this impulse will pass less quickly but will pass if our markets continue to perform reasonably well. T here will be a correlation between the kind of intelligent regulatory reform and the progress of our markets.

Let's go back to Alan Greenspan for a moment. ... As the 2000s are going along and 9/11 has happened and other things start to happen, what's he doing? What's he worrying about?

I think Alan worried about the markets all the time. Alan cared passionately about U.S. markets and probably knew more about them than anyone in the history of the Country. Was extremely thoughtful, sensitive, intelligent. Was not close-minded, was open to hearing presentations. He was firm in his philosophy and we certainly differed in a number of respects. But I would have to say that I regard Alan Greenspan as one of the greatest public servants in modern history in spite of what some regard as his failure to anticipate the problems in an overleveraged environment. We were lucky to have him as Chairman of the Fed.

He didn't seem to be concerned about where's the regulation, how do we manage this bubble?

I would say that more often than not, I had to prove to Alan why this regulation or that regulation made sense. I've always regarded the Federal Reserve as being the banker's protective association -- more concerned with safety and soundness than investor protection. And my obsession was investor protection. I couldn't care less about safety and soundness; that was part of the system. But if you don't have the confidence of investors, if you don't have the protections that are offered by private rights of action and the enforcement activities of the SEC, you have a universe of investors that don't trust and we can't have markets that aren't trustworthy.

After the 2008 meltdown last fall when he sits before Congress, ... it's got to be an incredibly painful moment for him, that sort of mea culpa moment. What did you think when you saw that happening to him?

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I thought that this is a stand-up guy that is realistic; that knows that life in Washington places people at the mercy of factors that are very often beyond their control; that good markets made all of us in that era look smarter than we really were. And when things change, we pay a price for that.

And I think all of us who went through this period all made mistakes and wish that we had done some things differently. I don't think there's anybody who's served more than a year-or-so in Washington that wouldn't say the same thing.

And now the proposals are all out there and there's the President's proposal and there's other ones. ... What's your favorite proposal that's likely or that has a chance?

I was co-chair with [former SEC Chair] Bill Donaldson of the Investors Working Group and Brooksley Born was a very important member of that group. We felt that systemic regulation should not be housed with the Federal Reserve Board and should be the function of a separate -- either individual or committee -- working with regulators in a coordinated fashion to warn them of systemic risks, to alert them to problems, and if necessary to take action. We felt that the Federal Reserve Board -- with their concerns for monetary policy and certain inherent conflicts -- that may make the policy-making decisions of a systemic regulator much more difficult. So we view Treasury's recommendation somewhat differently.

The likelihood of the administration, the likelihood of Congress of supporting this idea?

I think Congress has a lot of reservations about vesting the power in the Federal Reserve Board. Iit wouldn't surprise me to see an alternative not too dissimilar from our recommendation emerge. ...

When Born issued the concept release, there was a fear that the markets would all go to London. How prevalent was that fear? How important was that consideration?

During that period of time, every regulatory effort that the commission conceived of was met by an industry's insistence that the markets would all move to London. I never bought that notion; I never cared if they all went to London. And that argument is still being used today and it's specious. Regulations we're likely to see in other parts of the World are probably more draconian than anything we're likely to come up with.

So those arguments are ridiculous. And the irony of all this is that barely a year before the current market meltdown occurred, a group of eminent academics -- including the dean of the Columbia Business School, Sen. [Charles] Schumer [D-N.Y.], [New York City] Mayor [Michael] Bloomberg and others -- convened a group to say that the problem with U.S. markets was that they were overregulated and we were losing listings to London. To think that the metric of evaluating the U.S. economy was the number of listings lost by the New York Stock Exchange to the London Stock Exchange is so patently ridiculous, it's laughable today.

It's like an ongoing fear-based strategy, though, isn't it?

Yes, it is. ...

In that period, you said the argument [against Born's proposal] was that you'd be retroactively canceling contracts that existed. Where was that argument coming from? Who were you hearing that from? ...

Bob Rubin and Alan Greenspan.38

And how were they getting it?

It was a fact. It was a fact that there were trillions of dollars of notional contracts that would be thrown into total chaos. They were right; they were absolutely right. Having said that, great let's grandfather them and -- going forward -- let's keep this from growing the way it did in an unregulated environment.

How did it happen that that didn't happen -- that idea of "Let's grandfather it"?

Nobody was farsighted enough or bold enough. Or who knows why an idea does or does not occur?

Born says that within their concept release, it was stated that they would grandfather.

I cannot recall that. I cannot recall anyone saying that to me. And it's something that I should have known about and done something about.

Do you think the swaps played any role in the crisis?

I think I would argue that the swaps had very little to do with what eventuated.

But if you regulated the swaps, if you'd gone down that road, would that have led to --

Yes, of course.

I guess that's the connection that if you got one part of it, you'd have gotten the other?

Absolutely. If you decided derivatives were not products used just by very sophisticated professionals who knew how to protect themselves, once you cross that bridge, the rest is easy.

After you leave, what's the state of regulation of the financial services just in general? What happens over the next 8 years? Is it a period where there's continuing deregulation of the industry?

Listen, we had more regulation. We changed from markets with obscene spreads and collusive behavior by the over-the-counter market to an electronic market where billions of dollars a year were transferred from brokers' pockets to investors' pockets. We blew the whistle on the accounting conflicts; we implemented regulation, full disclosure. We probably were the most regulatory commission in spite of congressional pressure. ...

Michael GreenbergDirector / CFTC Division of Trading and Markets (1997-1999)

Michael Greenberger served as director of the Division of Trading and Markets at the Commodity Futures Trading Commission [CFTC] from 1997 to 1999. He currently heads the University of Maryland's Center for Health and Homeland Security and teaches the class Futures, Options and Derivatives at the University of Maryland School of Law. This is the edited transcript of an interview conducted on July 14, 2009.

... How high is [then-Federal Reserve Board Chair] Alan Greenspan riding in the mid-90s?39

... In October -- I think it was Oct. 22, '97 -- the stock market crashed again, went down I think 522 points -- something like that. And boom! the President's Working Group is called together. ... So I attend the first meeting … and it's clear at that point that Greenspan is a very, very powerful person. He has got the attention of everybody in the room. He's held in great esteem. ...

And of course that problem -- the failure and break in the stock market -- wasn't a direct impact on the CFTC [Commodity Futures Tradition Commission although when you have a crash of that kind, it affects all markets. And what you're especially worried about is the ability of investors to make margin calls. The equities market, you can buy a stock on 50 percent margin. In other words, you can borrow 50 percent of the money. The futures market is you only have to put down 4 percent to 7 percent; the rest is all borrowed money. And the reason for that in its best and most important phase, it's a risk-shifting market where people in the commercial businesses are hedging their risk. It's more of an insurance policy than it is an investment. ...

So when this crash took place, somebody who's taking a beating in the stock market may not be able to make their margin calls in the futures market. Simply put, the burden that I had was checking with all the futures exchanges. "Are you going to make your margin calls? Are people reporting?" Because if they don't, the exchangers are exposed. They're the ones who are effectively lending the money. And if they don't get paid the margin, they could go busto! and that would cause systemic risk for the Economy. And that's what everybody's worried about. Just as we know from the present credit crisis -- one big institution fails; it can't pay its obligations; it forces somebody else into a dangerous territory who can't pay their obligations; and pretty soon it's a falling domino effect through the Economy. ...

... When you start, even knowing [then-CFTC Chair] Ms. [Brooksley] Born just a little bit, what could you tell fairly early on ... she was up against?

First of all, I knew she was very bright. But now I'm getting to see it firsthand. She's very bright; she knows everything. She's got a phenomenal memory. She manages people well. And you really feel like you're in the presence of somebody who's a very special person personality-wise, intelligence-wise, and management-wise. And I can't emphasize enough that when the market goes down like it did then -- which is a very substantial drop -- there's panic in the streets. She is calm, cool, and collected through the entire process. And it's not that she's delegating out responsibility. She is really managing the ship. ...

Did she know anything about the business? ...

Brooksley -- who is a very well-established, broad-agenda lawyer at a very prominent firm -- knows about commodities. She's been involved in the Hunt brothers' investigation which is the famous cornering of the silver market. She's represented, I think, the London Stock Exchange or the London Futures Market. So she knows this statute -- the Commodity Exchange Act -- which is terribly written and very, very complicated. You can't just pick it up and read it. She knows it. She knows the players; she knows the people. So she comes into this job fully armed with the knowledge to be able to deal with it effectively.

But the CFTC is not a big agency. Is it overwhelmed in terms of what's out there that it needs to do, if it can do it?

That's an interesting thing. I never viewed us as being overwhelmed. ... What I did feel was ... too often the agency was in a situation of being captured where instead of regulating the industry, the

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industry was regulating the commission. And ... there were exceptions to that. But that's the overall history.

It doesn't sound like Brooksley Born is somebody who wants to take a job and just kind of work for the industry. She wants to regulate?

Brooksley comes in. She wants to be an effective regulator. Part of her job was to bring in top-flight lawyers and other professionals. She built an infrastructure that was very effective and smooth-working. So the only change here is not a sense that we're overwhelmed. The change is that the industry is saying: "Whoa, wait a minute! We can't tell these people to jump and then when they ask how high to tell them how high. Now they're telling us what needs to be done! They're enforcing the Law."

In this vein, I don't want to take you too far off track. But in my division there was a policy that lawyers could come in and say: "Look, we have a question that we view as being ambiguous under the Law. We want to get a staff letter from you that tells us we can go ahead and do this and we won't be subject to enforcement." And these are called no-action letters -- "no-action" meaning the enforcement division will take no action if you commit to do what you tell us you're going to do.

One of the first things Brooksley tells me when I walk in the door: "You be very careful of this no-action process because this is not a question of what the letter says; it's a question of who signs the letter." And there are a group of highly-favored lawyers who whatever they say they want to do, arguably ambiguous, in many instances clearly in conflict with the Law, they're going to get a letter back saying "It's fine." ... So there's all this low-level favoritism going on.

Now, Brooksley and I look at this and we say: "This is not the way the system is going to work. If you need these kinds of exemptions" -- we established a rule -- "here's the way it needs to be filed. Here are the set of facts you have to set out. Here's the law you have to cite. And this has to be a regularized, objective, neutral process." Before we got there, it was a matter of who signed the letter. ...

I read that she was one of the finalists for attorney general. True?

She had developed a very close relationship with Hillary Clinton when Hillary was a very prominent lawyer in Little Rock, Ark. ... When [President Bill] Clinton got elected, I remembered hearing the story that Mrs. Clinton and Clinton and a group were bandying about who would be the Attorney General and somebody said: "Well, Brooksley Born would be a good Attorney General." ... And Brooksley went in for an interview with Clinton. The story comes back was that Clinton found her boring and that it never went anywhere. ...

I think to some extent you could view this position as head of the CFTC as a consolation prize. ... To the general world, people who knew Brooksley, the circles she traveled, the American Bar Association, the D.C. Bar, and all the prestigious boards she served on, people were probably scratching their heads. ...

... [Former Treasury Secretaries Robert] Rubin, [Larry] Summers, [former Securities and Exchange Commission Chair Arthur] Levitt, and Greenspan, I wonder what they thought of this woman who comes in and takes this job. ...

I don't think that either Rubin, Greenspan, Levitt, or Summers knew who Brooksley Born was. And one of the messages of this story is that although they're 200-and-some miles apart, Wall Street and the

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D.C. Bar, the prominent lawyers in Washington, D.C., could be on opposite sides of the World. They just didn't know who she was. And moreover, they didn't really care. ...

Secondly, they don't have a real good understanding -- from where I'm sitting -- of what the CFTC does. They think it's backwater; they think it's pork bellies. ... And I think throughout the entire crisis we went through, they had no idea who they were dealing with. They never took the time to figure out that this was a very accomplished, smart, highly ethical and charming woman.

You mentioned -- and we've read some about -- this lunch that she has early on in her tenure with Greenspan. Tell me what you know about it.

When I went to work with her and she was telling me "This is what you're up against", she told me that she had had this lunch with Alan Greenspan and he had said to her probably that she and he were going to have a disagreement about something. And that subject was fraud. He didn't believe that fraud was something that needed to be enforced or was something that regulators should worry about and he assumed she probably did. And of course she did. I've never met a financial regulator who didn't feel that fraud was part of their mission. But that was her introduction to Alan Greenspan.

What does it tell you -- what did it tell her -- that he didn't believe fraud was a problem?

From what it told her and from what I could see in my observations of Alan Greenspan was that this was a man who was living almost in another era. That he was a total believer that the markets were self-correcting. For example, the reason he thought that fraud shouldn't be the worry of regulators is, well, if somebody committed fraud in the business community, the rational workings of the market would be that people wouldn't do business with that person and therefore they would die on the vine. And so the free market self-corrects and takes care of fraudulent actors. ...

... Is Greenspan admired, elevated, unquestioned? Is there something about him by then -- is he just untouchable?

Yes. Look, the economy by-and-large in this period is booming. There are hiccups. Y ou have the Asian financial crisis, the default on the Russian ruble. Later on, you have the Long-Term Capital Management [LTCM] fiasco. But basically it's an upward move. We're in the middle of the dot-com bubble. ... He is a force to contend with. He's very, very highly regarded although there's an understanding that he's coming at issues from a very orthodox free-market view and he's not happy with the regulatory structure. He's tolerating it. He's not happy about it. ...

Rubin spent a lot of time catering to Alan Greenspan's whims. ... But as much as he was inclined to cater to Greenspan, for one reason or another he only dealt with Brooksley as a sort of foreign power. And maybe a banana republic foreign power rather than somebody he needed to spend the same amount of time catering to.

Do you have any explanation for that?

A lot of people have guessed about it. Some people have said "Oh, she was a woman" or whatever. I don't put a lot of stock in the fact that she was a woman. I put a lot of stock in the fact he never took the time to understand who she was and that she was a person in her own right who should have been listened to, even if on first blush you didn't agree with the direction she was going in. I feel very confident that Bob Rubin didn't agree with everything Alan Greenspan told him but he made it a high priority to deal with and embrace and work with Alan Greenspan. Had he done the same thing with

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Brooksley Born, I think there's a good chance we would today be sitting here on a very healthy, thriving Economy. ...

What were the early warning signs about derivatives?

In 1994, you have the failure of Orange County, Calif. Goes bankrupt dealing in these unregulated, over-the-counter derivatives. The financial officer of Orange County doesn't understand the products he's dealing with and gets taken to the cleaners by the banks he's dealing with. And if you go to the popular media, everybody knows Orange County has failed. Everybody knows they failed because they were dealing with these highly toxic, complex, unregulated instruments. It's a source, almost, of common parlance. A county, at that point, a county had actually gone bankrupt. It was rather remarkable.

At the same time within the financial services industry, there's this major scandal at Bankers Trust where they have taken two of their customers -- Procter&Gamble and Gibson Greeting Cards -- to the cleaners with these complex over-the-counter derivative products. And unfortunately for Bankers Trust, it's all caught on tape in the exchanges not only between Bankers Trust and their customers. But the laughing up the sleeves of the salespeople about how they've taken these Fortune 500 companies to the cleaners. ...

And in fact, legislation is introduced. They wanted to set up a derivatives regulatory commission that would focus expressly on this subject. But at the time, the urban legend is that Lloyd Bentsen -- who was then Secretary of the Treasury -- went up to the Hill and said: "Look, we have this thing called the President's Working Group on Financial Markets. This is really a problem of a lack of coordination between the Fed, the Treasury, the SEC, and the CFTC. We will make this our highest priority. We can deal with this within the existing structure and don't you worry your pretty little heads about this."

So '94 goes by; '95 goes by; '96 goes by; '97 goes by. By '98, nobody's done anything about it. And while there aren't the kinds of dramatic scenarios that Orange County and Bankers Trust revealed in '94, there's a series of school boards being taken to the cleaners, cities being taken to the cleaners, and Brooksley just finally said: "These guys are operating outside of the legal structure. Somebody has got to do something about it because if they don't, there's going to be a calamity." ...

And when you guys take over, how big is the over-the-counter derivatives market?

When I first walk in the door, Brooksley said to me: "This is a $13 trillion market." ... By the time in May 1998 that we actually try to do something about it, it is a $27 trillion market. By the time Congress in December of 2000 deregulates it, it's an $80 trillion market. As we sit here today, the market has dropped from above $600 trillion to $592 trillion notional value. It's dropped because of the meltdown. ...

And obviously, it went from $13 to $27 to $80 to $600 trillion because nobody's watching the market. And in fact as we went through the economic collapse, these products are exploding all over the place coming to us in the form of, most prominently, credit default swaps. The panic in the market and the tightness of credit is a direct reflection that these products are spread all over the place and somebody who today looks highly profitable has got these products' off-balance sheets on things called "structured investment" vehicles. So they're hidden like land mines in a battlefield. Nobody wants to give money to anybody else because they don't know, are you sitting on top of products like AIG [American International Group] was sitting on top of that takes you from the biggest insurance company in the World to bust to 80 percent owned by the United States government?

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... Here's a contagion that literally metastasizes exponentially across the '90s and the early part of the 2000s.

Absolutely. ... The template is clear. Crisis caused '94 Orange County-Bankers Trust. Panic in the streets, we're going to fix it. Time passes; it cures itself. Lobbying takes over by the financial (i.e., services) industry]. All is forgotten.

It happens again in late '98 when Long-Term Capital Management fails. ... You have a crisis that now looks like a picnic. But at the time, everybody -- including Alan Greenspan -- was sobered by that episode. Even the conservative House Financial Services Committee: "What can we do to make sure this doesn't happen again?" Opportunity for regulation but time passes, problem solved, it solves itself, all is forgotten. ...

By [Jan. 1, 1998], there was stuff in The Wall Street Journal about school boards taken to the cleaners over these things. I don't remember exactly how it developed within the agency, but Brooksley and I talked about it. Something needs to be done. I said: "Let me think about it." And I assembled a small team of people within the Division of Trading and Markets and we sort of gave it the name the "Manhattan Project."

And we put people to work on. In the financial services regulatory system, there is a regulatory vehicle called a "concept release". Essentially it's a very preliminary white paper delivered by the regulatory agency -- most often used by the CFTC and the SEC. ...

Our two goals were (1) to present the problem and (2) to propose a broad range of possible solutions to the problem without reaching any conclusions. So we began working on this. Brooksley had the conception that she wasn't worried about the rest of the Administration. She was worried about the financial services industry. That we were effectively now going to say swaps are futures (the dirty words) and that this would meet a lot of resistance.

Because?

Because it meant that this multitrillion-dollar market would now have to be traded transparently with capital reserves, with fraud and manipulation requirements, with the regulation of intermediaries, and on organized exchanges rather than this private little gamesmanship where it was. ...

We aren't going to take it over. It's not going to be Government-run but it's got to be done transparently. Everybody needs to know what's happening. It's got to be overseen by a regulator who ensures that fraud and manipulation are not conducted within those markets. We've got to make sure that when people make commitments, they have the capital to back those commitments up. ...

Now we're not saying in the concept release that we're going to put the full regulatory template in place. We have the authority to exempt it from the full regulatory template. But something's got to be done and here's a list of questions and a list of proposals about what might be done. Should it be a transparent market? Should we ensure adequate capital reserves? Should it be subject to fraud? Should it be subject to manipulation? Should the intermediaries be regulated? Should there be adequate capital protections? That's what the concept release was. ...

One thing I think must be made very clear is we didn't do this in secret. Brooksley called in every representative of every leading financial trade association and institution. I sat in some of those meetings. She brought them into her personal office and said: "This market has caused problems. It's subject to the Commodity Exchange Act. It's supposed to be a transparent, protected market. It's not.

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We think the time has come to address it." And they were then called the International [Swap] Dealers Association -- it's now the International Swaps and Derivatives Association, a branding issue there -- they all came in, they all were explained this, and nobody said: "Oh my God! You're going to cause the worst financial crisis." I mean, they either sat there and said nothing or some people said: "You know, it's about time somebody's going to do this."

The second transparent thing we did is sometime in March, we had a draft of the concept release. We sent it far and wide. Whoever wanted it, we sent it to all the other regulators, all the financial institutions. We sent it to Congress. ...

There were 2 first shots across the bow, a double shot. One was I walk into Brooksley's office one day. The blood has drained from her face. She's hanging up the telephone and said to me: "That was Larry Summers. He says 'You're going to cause the worst financial crisis since the end of World War II'"; that he has, my memory is, 13 bankers in his office who informed him of this. "Stop, right away. No more." ... It was not done in a tactful way, I'm quite confident of that.

Why is he acting that way? What power do the 13 in his office have? What's that all about?

... A lot of this has to do with finance contributions, political contributions.

I mean, 1998 is an election year, right? A midterm election year?

Look, every two years is an election year and what is a lot of campaign contributions to members of Congress is chump change to the financial services industry. There was a recent report in the House Agriculture] Committee which is the committee of jurisdiction [for the CFTC]. I think the figure was $27 million from financial services, $9 million from the agriculture community. Now to them, $27 million is a lot of money. But do you think $27 million is a lot of money to Goldman Sachs or Morgan Stanley?

But these people speak with tremendous power and we see the template -- crisis, worry, threatened reform, pull back from the crisis, 24/7 lobbying, all is forgotten. And as we sit here today, we're experiencing that a feeling that the crisis of the fall of 2008/winter of 2009 we've now survived. Goldman Sachs just reported record profits and the pushback is coming to the reforms that have been proposed.

But at that time, why do the banks have such clout inside the Clinton administration?

It's a very interesting question. I think one of the driving forces politically at that time was that the financial services industry was essentially a Republican-captured institution and that these were the New Democrats that were going to prove to the financial services industry that they could do better. The Economy is booming. You've never made so much money. Don't look to the Republicans as your saving grace. Look to the Bob Rubins of this world who are melding Democratic politics with a growth economy. ...

When Born gets the call from Summers, what's her aspect and counsel to you and others? ...

Look, we're all grown people. We're all heavily experienced. We've all been around the block before. Each of us has gone through various crucibles in our lives. I was a litigator for 25 years; I appeared in courts across the Country. I argued cases in the United States Supreme Court. My colleagues that she had brought in were the same way.

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There was just a feeling -- it was an unspoken assumption -- that we're going forward. We'll deal with whoever we need to deal with. We'll be open and candid, we'll make our best arguments. But this is the right thing to do.

Did you worry about how vociferous it could be?

I think the first thing that caused me to worry about it was the April 21 meeting of the President's Working Group which was a very, very, very tense meeting. But up until that point, I think we felt Look! this wasn't a matter of discretion. We were given the responsibility to regulate futures markets, to make sure they were transparent, that there were capital reserves, there was no fraud, no manipulation. Here's a market that's a futures market. It's got nothing and it's up to $27 trillion notional value. You can tell us "Don't do this" ... But this is our constitutional job. Brooksley took an oath to uphold the laws of the United States. These are the laws of the United States and we didn't bat an eyelash about it. And frankly, she has the support of the other commissioners on the CFTC up to that point as well.

Republican and Democrat?

Republican and Democrat.

Okay. So the meeting is called for the 21st. … Is it a walk? Where is the meeting?

The meeting is at the Treasury in this ornate conference room off the Secretary's office where these meetings are held. The meetings are usually well attended. This was standing room only.

Why?

Because it was known this was going to be a major showdown. That Rubin, Greenspan and Levitt were going to try and stop Brooksley from doing this.

Shootout at the O. K. Corral?

... You would think that if this issue has reached the level it's reached that Bob Rubin would pick up the phone and say: "Brooksley, let's sit down and talk about this. I want to understand what you're doing. Let's see."

But no, it is the shootout at the O.K. Corral. No diplomacy, no picking up the phone. And by the way, during this period Rubin would not take Brooksley's phone calls. He would not take Brooksley's phone calls! ...

So it's April 21, 1998. The players are arrayed.

... It was Brooksley, [then-CFTC General Counsel] Dan [Waldman], [then-Chief of Staff] Susan Lee, and I go to this meeting. We're driven there. We get out at the entrance of the Treasury, go up to the room, everybody assembles. The Secretary walks in; the meeting is called to order. And the subject of the meeting was to discuss the concept release. The clear mission of it was to convince Brooksley that it shouldn't be issued.

What's she like at that moment? Is she tense? Was she nervous? How do you read her?

She's extremely professional. She has a capability of being a very charming and funny person. But I think quite appropriately in that setting, she's dealing with it as she would in litigation -- or I would in

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litigation -- as a very serious matter. So she is professional, organized, orderly, and matter-of-fact about what she's doing. It was a very, very tense meeting. Nobody lost their temper; nobody shouted. But short of that, it was made absolutely clear that virtually everyone in that room wanted her to stop that concept release and used very strong terms in making those arguments including that this would cause a financial calamity.

So you've told us before of an exchange you witnessed where Greenspan turns to her. Tell me about that.

Each of the principals in turn -- that is to say Rubin, Greenspan, and Levitt -- take their shot at telling Brooksley that she shouldn't do what she's doing.

I happen to be sitting behind Brooksley and behind Greenspan. They're sitting next to each other. Greenspan turns to her, she turns to him. His face is red and he's clearly quite upset. He certainly did not in any way raise his voice or do anything that would be unprofessional. But he was very adamant that this was a serious, serious mistake. That it would cause untold damages to the financial services market. And that she should stop and not do this, that it was unwise and would cause tremendous damage. ...

Did she fight back?

Oh yeah. Well, fight -- I want to be careful. She -- in a very professional, orderly fashion -- met each argument head on and gave her response to it. ... But people were coming at her from all sides.

The point has been made by some of these gentlemen that she's strident or difficult to deal with. Many of them wouldn't talk to her on the phone. But in that meeting, she was not a charming, motherly person. She was a professional and they may have been looking for something softer in their images. But she acted as anybody would act under those circumstances. And it was not a comfortable setting because she had no allies at the table.

How long did it last?

My memory is that it was about an hour or an hour and 15 minutes. The interesting exchange came at the very end. Rubin said to her: "I am told that you do not have the jurisdiction to do this." And Brooksley said: "Well, that's interesting. That's the first time I've ever heard that. All my lawyers at the CFTC have assured me that we have the exclusive jurisdiction to do this." And Rubin said: "Oh, you're listening to government lawyers. You shouldn't be listening to government lawyers; you should be listening to private lawyers. All the private lawyers representing the banks say you don't have the jurisdiction." ...

As someone who has spent 5 years in the federal government, I will tell you that you could give me a list of 500 lawyers from the Department of Justice -- people I do not know -- and I would take any of those 500 over the "private lawyers" he was referring to in terms of competence in understanding the Law. It was a tremendous insult to the professional government-lawyer staff in the United States Government at that point in time. ...

At the end of this lecture on listening to private lawyers rather than government lawyers, Rubin says to Brooksley: "Will you assure me that before you do anything with this concept release, you will discuss this with the Treasury Department lawyers?" And my remembrance is Brooksley said: "Of course." I was very comfortable with that because I felt -- all four of us felt -- there was no doubt that

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there was nobody at the Treasury Department who was going to convince us that we didn't have jurisdiction.

Rubin physically relaxed at that point. It was as if he had won the major purpose of the meeting. And all I could intuit from that was he was convinced that when these hicks from the CFTC talked to the powerful lawyers at the Department of Treasury, we would see the light of day and the concept release was done. ...

We go back to the CFTC and wait for the call from the Treasury Department. This is April 21. One week goes by, no call. Two weeks go by, no call. So Dan Waldman -- who was the general counsel, my memory is -- starts calling over there and saying: "Where's the meeting?" No response. May 6, 7 comes along and I go to see Brooksley and she says: "Look, we can't be slow-rolled into inaction by their refusal to talk to us. We're going to issue the concept release." I agreed completely. We had acted in the best of faith. They didn't call us. We tried to call them; they didn't call us back. We're an independent regulatory agency. This is our statutory mission.

So we issued the concept release. The release, my best memory is, is publicly released on May 8, doesn't appear at the Federal Register until May 12, the Federal Register being the government publication. It was released in the morning. By the afternoon, Rubin, Greenspan, Levitt put out a statement saying this is a very bad thing and Congress should act with all deliberate speed to block it. ...

… This is really playing the next heavy card by them, I take it. Is that what that's about?

It was a serious card. Again, going back to that point in time, you're dealing with a group of people who were deemed to be -- as Time magazine said -- "The Committee to Save the World." They wanted Congress to stop us and I think it was almost a foregone conclusion that that was going to happen.

Legislation was introduced to block us for one year from doing anything in the concept release. Hearings were held on it; Brooksley testified. She had no support anywhere. The people who had previously said "This makes sense" or "Let's look at it" or "These are only questions" were now of the view that we were causing serious problems that would lead to a systemic break in the Economy. And she started receiving hostile communications from every direction. ...

Bear in mind through all this, too, the Democratic Party is basically not a party highly skilled in the financial services sector. That was what Bob Rubin brought to the table -- a Democrat who understood the sector and was going to deal with it. And so Brooksley is a person who fights for the homeless, women's rights, civil liberties, and all sorts of issues that if she had been attacked on those grounds for doing any of those things, any number of Democrats would have said: "Hands off. She's doing the right thing."

But here we're talking about a time when the Democratic Party -- save these Rubinistas -- don't know the first thing about these markets. This is like off everybody's radar screen, so there's no natural constituency anywhere to come to her defense. And the people who are being lobbied about it are angry as they could be, not returning phone calls, being mean to her, hostile. It's a very, very unfriendly environment. ...

And Brooksley's oft-repeated mantra was that: "If you're troubled by us doing this, fine. Someone's got to do it. You want the SEC to do it? Fine. You want the Treasury to do it? Fine. But this is a world-class problem." And she used to say she would lay awake at night turning in her bed because she could see the crisis coming down the road building and building. And now we've seen that historically. ...

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Were you amazed by the vehemence of the reaction? ...

What amazed me more than anything else when I became adjusted to it was the ... refusal to sort of sit down, get everybody in a room and sit down, and say "Let's work this thing out", the refusal to sort of let us explain ourselves. ...

How do you know about LTCM melting down? What are you thinking? How are you hearing about it?

You start seeing articles in The Wall Street Journal. LTCM, this market is private, opaque. Nobody in the Federal Government knows what's going on. ... LTCM was like wow! They had had 46 percent, 40 percent, 20 percent returns in the prior 3 years before the collapse. In January 1998, they're giving money back to their investors because they don't know how to invest it all. Those investors are suing LTCM for turning back money that they want them to invest.

So LTCM is a black box. But the Journal in September '98 starts reporting they're experiencing losses. I think they started in 1998 with $4.4 billion. I know by the time of the collapse, they're down to $400,000. So somebody's lost $4.4 billion. What does that mean? Nobody knows that $4.4 billion, they're leveraged 125:1. It's not 4.4. It's 4.4 times 125. ...

If you want to invest in Long-Term Capital Management, you've got to walk into a conference room, abandon computers, abandon pencils, abandon yellow pads, no notes, and you're told there's a black box. Look at these returns: 46 percent, 40 percent, 20 percent. People are fighting to get in to invest. People are fighting to lend money to Long-Term. They know they're leveraged. But nobody knows they're leveraged like this. People are fighting to be their counterparties because they're transacting all these things in these swaps transactions. They need to have a counterparty to take the other end of the transaction. And banks will do that for a very nice price. There's a great commission that goes with that. ... But every bank thinks it's the sole lender to Long-Term; it's the sole counterparty. ...

It's Friday afternoon when ... the president of the New York Fed receives a call. ... What we know historically is that Monday, Tuesday, and Wednesday, the banks are informed. They're sitting around in, again, another ornate conference table in the New York Fed which is like a fortress on Wall Street. And look to your left, look to your right. Each of you has loaned enormous sums of money to Long-Term Capital Management. For every dollar they have now, they've borrowed $125. That is yours. If they collapse and go bankrupt, it's going to be a house of cards and it is our belief that your financial stability is in jeopardy. And the way to solve this problem is for you each to pony up $400 million and buy the fund, prevent it from collapsing, and try to work the thing out.

The fact that this happens between Monday morning and Wednesday morning is remarkable and only evidences the fact of how serious the problem was. The banks are shocked. They don't know that all these other banks are involved. They don't know all the other banks are lending, all the other banks are counterparties. But they agree, unhappily, because in those days $400 million was a lot of money. They unhappily agree to buy the fund. ...

There is a conference call that is set up for the steering committee of the President's Working Group. I believe we took the call in Brooksley's conference room off her office. I believe she listened into the call. The chief operating officer of the New York Fed made the call and he articulated to the rest of the federal financial regulatory system what had happened. This was all unknown that LTCM had called [then-New York Fed Chair Bill] McDonough on Friday. They'd gone out, the World was going to come to an End, and they've saved the day by getting all the banks to agree to buy the fund out.

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You mean you're all sitting there and you had no idea this had happened?

No, nobody told anybody about it.

So stunning.

Very stunning. Very stunning. And of course it's clear that the transactions that Long-Term is involved in are the over-the-counter derivative transactions which we say should not be hidden from the Federal Government, should not be leveraged 125:1; that there should be capital reserves to make sure payments are made; that this should not come as a surprise and require a -- thank God! -- call from Long-Term that they're in trouble because if they hadn't, it would have collapsed with nobody knowing about it. ...

This is a big earthshaking event and they have dodged not a bullet but a nuclear weapon by getting the banks to buy this, propping it up. And they are very sobered and very worried about this.

… It's a Cassandra-like moment, yes?

... We all looked at each other. I mean, it was like, you know, vindication. Vindication. Yeah, it was a big event. …

Oct. 1, 1998, [then-House Banking Committee Chair Jim] Leach [R-Iowa] calls the mother of all oversight hearings and Greenspan, McDonough, Levitt, Rubin, and Brooksley are individually called to opine on what happened. And this is a Republican-controlled House Financial Services Committee.

The moment is ripe. They are angry as they can be. If you go back to the transcript, these Republicans are saying: "This is the savings&loan crisis all over again. How could this happen? This is a moral hazard. This is too big to fail." Do those words sound familiar? ...

The message that goes forth from that hearing is, to Rubin: "You are the chair of the President's Working Group on Financial Markets. We want right away a report from you on what happened and how we can prevent this from ever happening again. Fast!" ...

Rubin now is trying to form a consensus within the 4 big players and he's getting Greenspan to make a lot of compromises toward a regulatory posture. Not quite far enough, though, that he's not got to worry about Brooksley coming from the other side. ...

The bank financial services community is in a state of high panic at this point and they get the idea. "We're going to be facing legislation; the game is going to be up." So the idea is that the financial services industry will start its own self-regulatory study of the problem. They create a group called the Counterparty Risk Management [Policy] Group. And every big name on Wall Street is either on the board of overseers or the staff of this group. They are going to mimic the President's Working Group on Financial Markets and they are going to come up with their own report. It is clearly designed to head off any kind of mandatory regulation.

So the President's Working Group comes out in April '99 with a decent report. Not a great report but a decent report. That's probably Bob Rubin's last act as Secretary of the Treasury. He steps down and Summers takes over.

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In June '99, the Counterparty Risk Management Group -- that is, the banks -- issue their report. It is a scathing discussion of how this market operates. There's a wonderful passage in it -- which I have my students read -- that says: "While oral contracts are enforceable, the better practice is to write these transactions down and execute them." And the tenor of the report is: "This market is the Wild West and the problem is there's no adult supervision."

And the industry commits itself to bringing this market under control and to put all these risk management controls to make sure that these 28-year-old salesmen who are selling these products are supervised by people who understand what's going on. No regulation is needed. We will take care of this ourselves, thank you very much.

Two things then happen. The bets that Long-Term Management placed that got them into trouble suddenly start paying off. So the banks who think they're losing all this money get all their money back, close the shop down, all is forgotten. ...

In November '99, the President's Working Group on Financial Markets issues a report. Brooksley is gone. I'm gone. Dan's gone. "These markets should be unregulated because there has been so much uncertainty about them. Because of the CFTC saying that they should be, this has been troubling to these markets. It hasn't allowed them to grow. The market will be limited henceforth to 'sophisticated investors,' not the widow and orphan. They won't be able to invest in it. But companies with names like Lehman Brothers, Bear Stearns, AIG, Merrill Lynch -- they're savvy -- will take control of these markets." And actually the thresholds are companies with over $5 million in assets are entitled to trade these unregulated.

They push the recommendation forward to Congress: Deregulate it. ...

On the very last day of the lame-duck Congress, Dec. 15, 2000, suddenly out of the conference committee report on the 11,000-page omnibus appropriation bill is a 262-page deregulatory bill for the over-the-counter derivative market. ... I doubt very much that there is one member of Congress or one staff member in Congress who read from end-to-end that legislation. I firmly believe that it was written on Wall Street. When they suddenly saw that they had a chance to pass it, they just threw everything under the kitchen sink into this bill. There are little exceptions to regulation that are next to bigger exceptions to regulations that make the little ones irrelevant. It's a dog's breakfast. But that is the Law that -- as we sit here today -- we operate under.

There's no doubt the CFTC cannot do anything about this. The SEC can do virtually nothing about it. This is an unregulated market -- no transparency, no capital reserve requirements, no prohibition on fraud, no prohibition on manipulation, no regulation of intermediaries. All the fundamental templates that we learned from the Great Depression are needed to have markets function smoothly are gone. ...

Back in the Oct. 1, 1998, House hearings that you talked about that Leach says Born has some reason to be vindicated …

To feel vindicated, I think he said … …

Greenspan also testifies. I think it's just an interesting point how stubbornly insistent Greenspan is at that point. He sees Long-Term Capital as proof that his philosophy is appropriate.

Yes. ... He had this utopian vision of markets working rationally the way that gentlemen function in the best clubs in London. And the market blew up in his face. It's not self-regulating. ...

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The big thing for me is the quandary that the Obama people now face. ... In a world where the banks contribute this much money, can anything ever be done?

Well, those are very good questions. And it's ironic because Obama has essentiality brought back many of the actors who were unsympathetic to our point of view in 1998, 1999, 2000.

However, from my perspective -- and I believe from Brooksley's perspective as well -- the lessons have been learned. Recently, the Treasury proposed a white paper. It's confused and not as clear as one would like. But embedded within it is a program that comes in the direction of where Brooksley and I were 10, 11 years ago. And many progressives have now reached the point where after the bailout of the banks and the banks now profiting while everybody else is unemployed, they've become disenchanted with the Department of Treasury and Secretary [Timothy] Geithner and are not willing to give any credit to efforts that are being made. My view -- I believe Brooksley's view -- is right now that they have put forward proposals that are meaningful and strong. ...

The benefit now -- and the difference now -- for Obama and the Treasury is (A) the understanding of what just happened; (B) people like [CFTC Chair] Gary Gensler (who was a Goldman Sachs partner and a protégé of Bob Rubin) have come back into power and they have given every evidence of the fact that they have learned their lesson. They are advocating the kinds of things that we advocated 10 or 11 years ago.

Right now, all I can tell you is that the battle is evenly matched. You would think after everything we've been through there shouldn't be a battle; it should be understood. No, no. The financial services industry has organized itself and will pitch very, very hard for continuing to have these markets be unobserved by anybody outside of the banking system or their customers. No capital requirements, no fraud controls, no manipulation controls, and no regulation of the intermediaries. It's going to be a close-fought battle.

Brooksley BornChair / Commodity Futures Trading Commission (CFTC) (1996-1999)

(As head of the Commodity Futures Trading Commission [CFTC], Brooksley Born became alarmed by the lack of oversight of the secretive, multitrillion-dollar over-the-counter derivatives market. Her attempts to regulate derivatives ran into fierce resistance from then-Fed Chairman Alan Greenspan, then-Treasury Secretary Robert Rubin and then-Deputy Treasury Secretary Larry Summers, who prevailed upon Congress to stop Born and limit future regulation. This is the edited transcript of an interview conducted on Aug. 28, 2009.)

So let's start with September 2008 as we all sat there and watched the economy melting down and heard about things called "credit default swaps" [CDS]. It wasn't the first time you'd heard of these sophisticated financial instruments. What did you think when you were watching it happen?

It was like my worst nightmare coming true. I had had enormous concerns about the over-the-counter derivatives [OTC] market -- including credit default swaps -- for a number of years. The market was totally opaque -- we now call it the "dark market". So nobody really knew what was going on in the market.

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And then it became obvious as Lehman Brothers failed, as AIG [American International Group] suddenly appeared to be on the brink of tremendous defaults and turned out had been a major credit default swap dealer and needed hundreds of billions of dollars to keep it alive, the contagion in the marketplace from those failures brought many, many of our biggest financial services companies to the brink of collapse. And it was very frightening.

... How did it happen?

I think it happened because there was no oversight of a very, very big, dynamic, growing market. Market participants don't look out for the public interest. Traditionally, Government has had to protect the public interest by overseeing the marketplace and keeping the extreme behavior under some check.

We had no regulation. No federal or state public official had any idea what was going on in those markets. So enormous leverage was permitted, enormous borrowing. There was also little-or-no capital being put up as collateral for the transactions. All the players in the marketplace were participants and counterparties to one another's contracts. This market had gotten to be over $680 trillion in notional value as of June 2008 when it topped up. I think that was the peak. And that is an enormous market. That's more than 10 times the gross national product of all the countries in the World.

... This was something that you discovered, heard about, came across, back in the mid-1990s?

Yes. When I was chair of the Commodity Futures Trading Commission [CFTC], I became aware of how quickly the over-the-counter derivatives market was growing, how little any of the federal regulators knew about it.

And also, we were seeing some very dangerous things happening in that market. There were some major fraud cases. There was use of over-the-counter derivatives to manipulate the price of commodities. And there were some spectacular failures by institutions that were speculating in the over-the-counter market with little or no restraint. For example, Orange County, Calif. was brought down, went into bankruptcy because of its speculation, gambling with public money in the over-the-counter derivatives market on interest rate swaps.

I became very concerned. This market had been under the jurisdiction of my agency and had been expanding for about 3 years when I came into office because one of my predecessors had led an effort to exempt these transactions from a requirement of exchange trading. So, by an exemption, the Commission had permitted the over-the-counter market to grow. And in the few years, 3 years, it had grown to something like $25 or $30 trillion in notional value. ...

And the astonishing thing -- at least for me as I began to learn about this -- was that nobody in Government knew how much, how big, where, or who the parties were at all.

That's correct. None of the other financial regulators knew about it either. And it seemed to me we all needed to know. There needed to be some light shone on this market so that we knew what kind of risks might be being created there.

We knew who the participants were. We did know that our biggest banks and investment banks were the dealers in the market and that they were being very profitable in their dealing in the market.

But who the buyers were, what the deal was, the spreading of the risk, was still, as you say, opaque?

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We just didn't have information. ...

What was the danger to the public that you were concerned about in the over-the-counter derivatives market?

First of all, we didn't truly know the dangers in the market because it was a "dark market". There was no transparency. But generally in any financial market, if there is not government oversight to control abuses like fraud and manipulation, to limit speculation, to make sure that a major default won't cause a domino effect throughout the economy, the public interest is exposed and in danger.

Beyond that and perhaps on a more specific level, I knew that the entities participating in the market were ones that all the people actually had interest in. They were the companies that people had invested in; they were the employers of many people; they were the pension funds for many retirees; they were the insurance companies for many people who were depending on those companies for their insurance. So I knew that all the people had an investment in stability in that market. ...

When you first got there, the Procter&Gamble lawsuit against Bankers Trust had already happened. Did it serve as a cautionary tale? Or had you known about it when it was happening? ...

I had known about it at the time it happened because my law practice was in the derivatives area. I'd practiced derivatives law for more than 20 years. So I kept apprised of notable cases and certainly Procter&Gamble and Gibson Greeting Cards' suits against Bankers Trust -- Bankers Trust being their over-the-counter derivatives dealer -- were very well known. So I was aware of that.

I was also aware that there had been some spectacular failures, collapses, by speculators in the market and that big institutions and a broad range of companies -- from pension funds to public entities like Orange County to corporations -- were speculating in the markets. But I did not have any idea of the size and complexity that the market had arrived at until I got to the CFTC and my staff began to say how big this was and how little information they had about it.

... People said: "Wait a minute! These are consenting adults in a swap, in a derivative deal. As sophisticated investors, they don't need regulation to protect them." Is what Orange County represents that maybe people are not sophisticated? ...

These are very complex instruments and the way they work is pretty complicated. Highly-sophisticated computer models are used by the OTC derivatives dealers to figure out values and the circumstances under which they would profit highly and the counterparty would lose. And those tools weren't available to the other parties -- what we then called the end users of the over-the-counter derivatives.

The other aspect of this was it may well be that Orange County was a big, sophisticated entity. Let's assume it was. But it was using the taxpayers' money so every single taxpayer in Orange County lost when Orange County lost. And it was the public interest that I was mostly interested in -- not so much the particular interest of individual players in the market.

... Did you know it was a territory you needed to get into to exercise your responsibilities as a public official?

I thought it was very important to do that. One thing I should make clear, too, is that while the CFTC had exempted the market from most of our regulation, ... my predecessors had retained fraud and

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manipulation prohibitions against the market. And when I got into office, I thought well, how can we detect these malfeasances? How do we deter them? I realized there was no record-keeping requirement imposed on participants in the market. There was no reporting. We had no information. The only way the CFTC found out about the Bankers Trust fraud was because Procter&Gamble and others filed suit. ...

How formidable a challenge is it for the head of the CFTC -- this slightly "off-to-the-side" agency -- to forge forward and make a mark in this burgeoning World?

It was a small agency and is a small agency today. I didn't think that we could send out demands to the biggest banks to report to us even though all of them were registered with us as futures and options traders. ...

But I felt that we did need to learn more about the market and we needed to test whether the balance that the Commission had earlier struck between exemption and keeping regulatory powers was appropriate.

So our Division of Trading and Markets under Michael Greenberger began -- at my request -- to prepare a list of questions that we needed answers to about the nature of the market. They prepared a document that listed the grounds for concern -- the previous fraud, the collapses in the market, the rapid growth, the fact that we didn't keep any enforcement tools to let us effectively police the markets for fraud and manipulation.

And it asked questions about the market. It also asked questions about whether certain changes needed to be made to the regulatory regime. Did there need to be record keeping? Should there be reporting to some federal regulator? Would clearing the transactions in a clearinghouse help protect against counterparty risk default on the part of one side or the other?

We called this paper the "concept release" [i.e., a report released to the public outlining a proposed rule change]. And eventually in May 1998, we published that in the Federal Register asking the market participants and the over-the-counter derivatives dealers for their input voluntarily to tell us about the market.

... Were you aware of the reaction that would befall you -- the CFTC -- as a result of just even talking about the concept release?

I thought asking questions couldn't hurt. And I was shocked that there was a strong negative reaction to merely asking questions about a market. I had considered this as one of 3 options before we went this direction. One was to pretend that the market wasn't there, which to some extent had been going on as the market was growing. I didn't think it would be a responsible act to ignore it when it seemed to at least pose the possibility of a real threat to the public interest.

Another possibility would have been to ask our enforcement division to bring actions against the largest banks and investment banks for violating the terms of the exemption because the exemption as it was initially adopted by the CFTC in 1993 exempted only customized contracts. It did not exempt standardized or fungible contracts because fungible contracts could be traded on exchange. And the philosophy was that they should be traded on exchange.

In fact, the way it became obvious to me that the way the market had evolved in the 3 years since the exemption was adopted was a lot of the market had become standardized and was not really appropriately exempted under the terms of the exemption. And that's one of the questions we asked in

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the concept release. Should we broaden the exemption to cover what's actually being traded out there in the over-the-counter market?

What was the response?

I wasn't too surprised at the reaction of the over-the-counter derivatives dealers because they believed in no regulation. Their position was that markets were self-regulatory, that this market was taking care of itself, there were no risks in the market, and they thought there was no need for any government oversight or regulation.

I was more surprised at the other financial regulators who also were quite ignorant about this market because I would have thought they would have welcomed information. I had hoped that they would work with us to learn more about the market, decide whether there was an appropriate regulatory regime for it. And if so, what?

But my reading of the times was there was no impulse to regulate; there was an impulse to deregulate. Everything was going just fine, thank you very much.

Well, that's true. We had had 15 years of deregulation up until then, really. And there was a great belief in the ability of the market to police itself without government intervention. Certainly that had shown itself in a lot of deregulatory actions that had been taken previously.

I was concerned about it because it seemed to me it overlooked the fact that market participants -- obviously and quite rightly -- would pursue their own interests rather than a broader public interest. And if systemic risk was being built up in the system, no individual participant would have any interest particularly in blowing a whistle or changing its behavior.

There were, of course, counter-arguments made. These markets are going to leave America; they're going to go to London. Your response?

... It is true that there was a suggestion that merely asking questions would drive our biggest banks and investment banks to London. That puzzled me. You know, what was it that was in this market that had to be hidden? Why did it have to be a completely "dark" market? So it made me very suspicious and troubled.

The other argument is this would abrogate deals that were already under way. ...

That was certainly said. This was called legal uncertainty. But we had made it clear in the concept release that we were looking forward; we were not concerned with existing contracts. We would not change the regulatory regime as to the existing contracts. Nor were we looking to police the market with respect to the legality or illegality of those contracts. What we were asking was should the regulatory regime be changed in the future?

As to the other regulators, the other people in the President's Working Group, was it your sense that they understood derivatives and how it was working? ...

... People there at the CFTC and people who had practiced law in the area as I had were, I'm sure, more aware of it than people who were essentially banking supervisors or securities regulators. There were securities options, of course, which are a kind of a derivative contract. So the SEC did have some experience in that area.

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I was not sure how much understanding there was of the derivatives markets by the other regulators. And in fact, one of the things we tried to do in the President's Working Group meetings was to explain our markets and what the concerns were.

But it fell on deaf ears?

Yes, there was very little interest in doing this. The markets were doing very well; the Country was very prosperous. There was a lot of financial innovation in this area. In fact, I know [former Federal Reserve Board Chairman] Alan Greenspan at one point in the late '90s said that the most important development in the financial markets in the '90s was the development of over-the-counter derivatives.

You think he understood what that meant?

Well, he has recently said that there was a flaw in his understanding.

When you proposed the concept release, there's an extraordinary statement from Greenspan, Rubin, and [former SEC head Arthur] Levitt that says Congress should pass legislation that prevents CFTC from oversight. How did you hear about it? Did you get a phone call? Do you remember?

I don't remember.

It was an extraordinary moment. What did you think?

I was very surprised because, of course, we were an independent Federal agency and we were acting within our jurisdiction. And ordinarily, the tradition has been and the understanding has been that independent regulatory agencies should be permitted to do their job as they saw fit. But obviously, the other financial regulators thought that this was terribly important for them to step in and condemn.

Why?

I think the reasons varied from department or agency. But one of the reasons was that some of the people involved really were purists in terms of belief in free markets and were absolutely -- from a doctrinal point of view -- opposed to regulation.

I think others were concerned with keeping the big banks and the investment banks happy and making sure that they were responsive to the demands of those entities.

One thing we have to remember is that the financial services industry was the largest campaign finance contributor then -- and perhaps even now, I'm not sure -- and it was very effective in lobbying both the Executive branch and Congress.

Could you feel that?

Yes. Oh, I felt that from the day I went into office as chair of the CFTC.

How?

I had all kinds of interest groups coming to meet with me on a daily basis to tell me how they wanted me to regulate. So I was the focus of some of these lobbying efforts. ...

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There was an argument that was made ... that what you were proposing ... would precipitate -- the quote was "the worst financial crisis since World War II." Did you hear that charge?

I did hear that. And that too puzzled me since we'd had a lot of financial ups-and-downs since World War II. And I, again, could not conceive of why asking questions about whether the public interest was adequately served by the limited degree of regulation of this market would be so inflammatory.

Actually, some of the economists at the CFTC did do a study at the time to see if the over-the-counter derivatives market was being roiled by the concept release. And they never found any evidence of it.

So why were they so worried?

I think the over-the-counter derivatives dealers were concerned that some additional regulation might be considered seriously. I certainly thought some was probably needed and the more resistance there was, the more I thought there probably was a need. And I think they were totally opposed to it.

Of course, this became a major profit center in each of the over-the-counter derivatives dealers business. It was something like 40 percent of the profits of many of these big banks as recently as a couple of years ago.

In the summer after the concept release (the summer of 1998), Long-Term Capital Management [LTCM] has a problem. How do you hear about the problem?

Yes, I got a call from the Treasury Department probably the weekend that it nearly collapsed. This was in actually September '98. I was told that the very large hedge fund was almost collapsing, that it had $1.25 trillion in notional value of over-the-counter derivatives and it only had $4 billion in capital to support that enormous investment and that the markets had turned against it, ... so that it was going to default in a very major way, leaving the counterparties in the derivatives contracts -- who happened to be the big OTC derivatives dealers -- in the lurch in a major way.

And I was told that the Federal Reserve Bank of New York was trying to facilitate an arrangement whereby the large over-the-counter derivatives dealers took over LTCM by buying it out.

What did you think when you heard that?

I thought that it was exactly what I had been worried about. None of us -- none of the regulators -- had known until Long-Term Capital Management phoned the Federal Reserve Bank of New York to say they were on the verge of collapse.

Why? Because we didn't have any information about the market. They had enormous leverage. Four billion dollars supporting $1.25 trillion in derivatives? Excessive leverage was clearly a big problem in the market. Speculation? I mean this was speculation -- gambling on prices, on interest rates and foreign exchange rates of a colossal nature. Prudential controls? I mean, all these big banks had in essence ... extended unlimited loans to LTCM and they hadn't done their homework. They didn't even know the extent of LTCM's exposures in the market or the fact that the other OTC derivatives dealers had been lending to them as well.

They thought they were the only bank and there were 13 others on the list, right?

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Well, at least there was a suggestion of that. There was some reporting of great surprise.

The other thing it showed me -- which I hadn't really been aware of before -- was the risk from tremendous contagion. Not only did these instruments -- which supposedly are useful for managing risk, it multiplied risk and spread it around throughout the economy -- but also because of counterparty risk, one institution's failure could potentially bring down or adversely affect a large number of our biggest financial institutions.

The Federal Reserve opinion was that had the OTC derivatives dealers not stepped in and taken responsibility, this could have had a widespread, adverse, systemic impact on the financial system. Meltdown?

Yes. A mini-2008 in effect.

One decade before?

Exactly. ...

So much for the argument that the market will somehow take care of itself and we don't need regulation, I guess?

It disproved it to me. I had never believed that. I think anybody who has been a lawyer practicing in areas involving business regulation realizes that the public interest is not fully protected by the marketplace and the participants in the marketplace.

So LTCM happens and for a brief period. there is this eagerness to regulate. ... But it very quickly evaporates. Why?

Because everything was all right. Because all the big banks did step in and solve the problem by taking over LTCM and incurring losses themselves. But they protected the fabric of the economy. And Congress was told by the over-the-counter derivatives dealers and some of the other regulators that this was an anomaly -- this was not indicative of dangers in the market.

And I think any consideration of regulation probably came-and-went within a few days because it was less than a month later that Congress passed a statute saying that the CFTC could take no regulatory action in the over-the-counter derivatives market for the next six months.

A moratorium.

Yes.

On Born?

True. Congress also said that it would like the President's Working Group to do a study of hedge funds like LTCM and of the over-the-counter derivatives market and report back to Congress about whether or not there were problems in the areas.

[House Banking Committee Chair] Jim Leach [R-Iowa] offers you an opportunity to take a victory lap, claim vindication. Why don't you at that moment in front of Congress?

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Because it seemed to me that the important thing was to focus on the dangers to the public and the need for reform. It was not whether somebody had predicted a danger that existed. I didn't think it was appropriate to take credit for something that was so potentially disastrous.

We've talked to people ... who say you worried a lot, a sleepless kind of worry. How accurate are those descriptions of how potent this felt to you?

I was extremely concerned and because of the way our statute was written, it was the CFTC who had regulatory responsibility for these markets. I felt that responsibility very heavily which was why I felt that it was extremely important for me to stick to my guns and repeat to Congress and the other regulators the reasons that I thought something needed to be done to close the regulatory gap that existed.

There are many people I've talked to -- reporters and others -- who say they can't remember such fierce fire ever being directed at somebody as was directed at you during those times. How did you withstand it?

I felt it was my public duty. I felt that I was doing my job.

Hard to do?

No. When I took the job, I knew that it was my responsibility in that position to look out for the interests of all of us and not just for the interests of some of the regulated parties like the over-the-counter derivatives dealers. I felt as long as I was in that position, that's what I should do.

Now once Congress created the moratorium, I felt that Congress and the Administration by passing the statute had relieved the commission of the responsibility. I did continue to speak, I think, after that about how important it was to address the issue. But I no longer thought it was my duty as chair of the CFTC to make sure that something bad didn't happen in the market.

You really thought something bad could happen, would happen?

Yes. LTCM was the sort of thing that I was concerned about. I did not foresee then the kind of pervasive and enormous collapse that we've experienced in the last year. Partly because the market wasn't that big yet. And partly because I didn't realize until LTCM happened how pervasive the contagion could be.

And how pervasive could it be?

I think it could include thousands of financial services industry participants and other large institutions all over the World. And I think that's what happened. As the market continued to grow with even less oversight and regulation until it reached more than $680 trillion in notional value, an enormous potential for disaster had grown.

What happened after I left the agency in June 1999 was that the President's Working Group did come out with an over-the-counter derivatives report to Congress that strongly suggested that ... there was no need for regulation.

As a result of that report, a statute was passed in 2000 called the Commodity Futures Modernization Act [CFMA] that took away all jurisdiction over over-the-counter derivatives from the CFTC. It also took away any potential jurisdiction on the part of the SEC and, in fact, forbids state regulators from

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interfering with the over-the-counter derivatives markets. In other words, it exempted it from all government oversight, all oversight on behalf of the public interest. And that's been the situation since 2000.

When the CFMA is passed, how do you feel? ... The end?

Of course it's never the end because I hope we can have regulation now. But at the time, I certainly strongly disagreed with the decision to do it. I mean, it was a terrible mistake and I felt as though we as a society were much more vulnerable than we should have been.

So we're the losers. Who were the winners?

I think the profits made by the over-the-counter derivatives dealers, by our largest banks and investment banks were the upside of this. And that was short-sighted. It was short-term benefit for a few major institutions at the expense of all the people who have lost their jobs, who have lost their retirement savings, who have lost their homes.

... What's the message that you're trying to spread now in the ashes of what happened in 2008 and 2009?

I think we have to close the regulatory gap. ... We cannot afford as a society to go forward with an enormous unregulated market that poses this kind of danger because it’ll happen again if we don't take the appropriate steps. ... We need to take a lesson from the existing futures markets where exchange trading has been safe. As much as possible of the over-the-counter derivatives market should be traded on a regulated derivatives exchange. The transaction should be cleared on a regulated clearinghouse. There should be robust federal regulation of any remaining OTC derivatives market. And personally, I think that remaining market should be limited as much as possible to no more than the customized contracts that are needed for specific businesses to hedge particular business risks. ...

If this moment passes again, the consequences are what from your perspective?

I think we will have continuing danger from these markets and that we will have repeats of the financial crisis. It may differ in details but there will be significant financial downturns and disasters attributed to this regulatory gap over-and-over until we learn from experience.

And the lesson you learned from your government experience?

It's an interesting question. I think the lesson is that a public servant has to do what she believes is right and carry her responsibility even if there are very adverse consequences in terms of criticism and other difficulties. That's one's job.

My parents were both public servants and I think I learned from them. My father was the director of public welfare in San Francisco for 35 years and my mother was a high school English teacher. They felt that public service was the highest calling -- that this was the way to give back to the society for all we enjoy every day. And one of the things you have to do is put aside self-interest, put aside ambition, and do what's right for the people. And that's what I tried to do. ...

Congress is the one, in the end, that had oversight over the regulators. How good a job were they doing? ...

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Of course, Congress has a critically important role since they -- along with the Administration -- have to decide on any kind of statutory reform. I think it's very difficult for a member of Congress to be an expert in every field. This is a complicated field. ... They had a lot of other things on their plate. They were hearing from very respectable sources that there was no problem and they chose to rely on those people. And I think that was understandable. I think it was unfortunate. But I think it was very understandable. ...

When your term expires, why did you leave the agency?

I was asked by the White House whether I would like another 5-year term. I had gone into the position thinking I would fill out the existing term and return to the practice of Law which was what I really loved to do. But by the time I was considering whether I wanted to stay on for another term, it was pretty clear -- because of the attitudes of the other financial regulators, because of the congressional action tying our hands -- that there was not anything effective that was going to happen in the over-the-counter derivatives area. And I felt as though because of that, I had done what I could to help protect the public; there wasn't much left for me to do; and that perhaps the agency would benefit from new blood who came in with new priorities.

... Did you know then the advantages of derivatives? Did you know enough about it to be able to understand why these things would have been invented and why they would be catching on like wildfire?

Oh definitely. Because futures and options are used the same way. They are a wonderful means of hedging risk or shifting risk from one entity to another. The whole reason we have derivatives exchanges is because commercial interests, agricultural interests, can in effect ensure against price changes or interest rate changes or other adverse business events by hedging through these instruments.

So in that sense, they're a good thing?

Exactly. And I would never say derivatives should be banned or forbidden.

So what's the problem?

The problem is that they can be extremely misused. These instruments offer 2 different roles to entities using it. One is to hedge price risk; the other is to gamble on price risk. There are means within the over-the-counter market to gamble on price changes in an enormous way, putting up very little up-front money so that entities are tremendously leveraged. And that means that they can make tremendous profits when the price moves right for them. But when it moves wrong, they can collapse like AIG did. ...

So what do the American people need to know about why this is so important to get after right now? And why it was so important for you?

Because this is a market that can impact each of us. It's AIG's collapse. It's the toxic assets on the books of many of our biggest banks that are over-the-counter derivatives and that caused the economic downturn that made us lose our savings, lose our jobs, lose our homes. We can't face repeated harm like this from a totally black market, a "dark market".

Do you think most people know there's no government regulation in this territory?

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I don't know if they do or not. All other financial markets have some kind of government oversight protecting the public interest.

But not this?

Not this one. This one had very good lobbyists. The very same entities that are lobbying today to limit the effectiveness of a new regulatory reform are the people who in 2000 and 1999 deregulated these markets entirely. ...

... I wonder about the extent to which your gender affected what happened with the members of the working group, the other regulators. What do you think?

I don't want to comment on that. I do think that some people -- some men -- may have problems in dealing with women as equals or listening to women's voices, particularly dealing with their disagreement with them.

Arthur Levitt says: "You know, if she just would have gotten to know us, ... maybe it would have gone a different way." Arthur now expresses true affection for you and says what a lovely person [you are] and that he was wrong and you were right and all this. He says it on camera. But he says,""Oh if only she would have --" What do you say?

I'm reminded of something that Michael Greenberger once said to me which is: "They say you weren't a team player. But I never saw them issue you a uniform." And I didn't feel as though I was being invited to be part of the team. ...

What was it like being one of the few women in Stanford Law School?

It was unusual because I'd come from coeducation institutions before -- including undergraduate studies in Stanford -- and it was strange to enter into a male-dominated institution like that. I think there were about 5 of us who graduated with my class out of a class of 100 -- 5 women. But on the other hand, I found that I made a lot of friends, worked on the Law Review, and had a very good time with a lot of colleagues and enjoyed myself.

The stories about your not getting a Supreme Court clerkship opportunity, how did that feel?

Remember, the society was very different then. I was part of the society so I understood why there was reluctance. There had never been a woman law clerk on the Supreme Court before. There had never been a woman president of the Stanford Law Review before. So I realized that this was change and that people have trouble adjusting to change. Our society was very different then and was used to having women in very traditional roles. ...

I was very disappointed not to be put up for a Supreme Court clerkship because I really, really was interested in doing that and I thought it was wrong. But I wasn't outraged because I could understand what the motives were.

... You had an interview with President Clinton to be Attorney General. How did that go?

I did. I had a good interview with him and I wasn't offered the job. I don't know why. It was his prerogative to decide who he wanted and he wanted Zoë Baird.

Was it a disappointment?63

It was on one level. I remember it happened right before Christmas. I was sitting Christmas morning in my living room with my 5 children, all of whom were fairly mature by then -- they were in their 20s and early 30s -- and the Christmas tree and all the presents and the sunshine flowing into the living room and thinking: "You know, the privacy and the personal life of a private person has something to offer it." So it was not an unmitigated disappointment.

Did the CFTC feel like a consolation prize?

No, I had no feeling that that's what it was. I had really decided after the Attorney General issue that I would not try to go into the administration in any role; that I was happy in my practice; that I enjoyed it; and that I would serve out the rest of my career in private practice without going into the Government.

What did they say to you to get you to do it?

They were very encouraging. I was approached by the Administration and a number of people were very encouraging. And of course, it had been the area of my practice for 20-some-odd years so it had that kind of appeal. It also was appealing to think about being in an institution that -- unlike a law firm -- was a hierarchical institution where, as chair, I would have administrative responsibilities and other responsibilities that you just don't see as a lawyer in private practice. ...

The famous Alan Greenspan lunch, did it actually happen?

I'm not going to talk about it. I'm not going to talk about it on camera.

Gary GenslerChair / CFTC (May, 2009 - Present)

(Gensler became chairman of the Commodity Futures Trading Commission in May 2009. He previously served as the U.S. Treasury Department assistant secretary of financial markets (1997-1999) and under secretary of domestic finance (1999-2001). Before joining the Treasury Department, Gensler worked at Goldman Sachs for 18 years. This is the edited transcript of an interview conducted on Aug. 6, 2009.)

So you've been out in front advocating for ... regulation of derivatives. Explain what you're thinking at this point.

I believe that we need to bring broad reform to the over-the-counter derivatives marketplace. We must lower the risk for the American public and increase the transparency of these markets. We have a gap in our regulatory structure today and unless we fill it, we won't be able to -- as I said -- lower the risk of the system and increase transparency.

The financial system failed the American public. It terribly failed the American public. And the financial regulatory system failed the American public. There are many parts of that failure. But one of the failures is that we have not been regulating the over-the-counter derivatives marketplace.

Some people will write that credit default swaps [CDS], other derivatives basically took the economy to the brink of disaster last year. Explain why, or your view of that.

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My view is that there are many root causes of this terrible calamity in the markets, in the financial system -- great global imbalances in savings rates and economic imbalances but also that the financial system itself and the financial regulators failed the American public because only part of that is the derivatives. But the over-the-counter derivatives allowed a great deal more risk to be taken in the system, and it also allowed certain financial companies -- unregulated by and large -- to take such a dominant amount of risk that it put homeowners in every state and ordinary citizens at great risk.

How do you see CFTC's role today and how has it evolved over the years?

The Commodity Futures Trading Commission was set up to oversee risk markets for not only agriculture commodities but also futures (which are a form of derivatives) and energy products and then financial products. Every day, an American can turn on their TV and see a little report as to what some things called the Dow Jones futures are trading or the stock market's futures, S&P [Standard & Poor] futures. We oversee the markets in these instruments.

We also believe we have to regulate derivatives that are not currently on exchanges. We need to bring them onto exchanges, bring them into central regulation. And the CFTC along with the Securities and Exchange Commission [SEC] can bring a great deal of expertise to protect the public. ...

The Commodity Futures Trading Commission has not historically regulated these over-the-counter derivatives -- what some people call swaps. This was because of its statute; it was because of numerous court cases; and it may have just been also due to the culture of the markets at that time.

What we need to do now, though, is we need to work with Congress to make sure that we have affirmatively the authority to regulate these markets.

This is the right place for that?

The Commodity Futures Trading Commission is an agency that oversees risk markets and the derivatives marketplace called futures. We think we have great expertise in this regard. But working along with the Securities and Exchange Commission -- because there's some products that should come under their jurisdiction as well -- I think that we can get this right for the American public.

During the 1990s -- especially mid- to late-'90s -- these products were growing much more complicated, and the markets were growing and growing. … You were at Treasury. What was the attitude toward regulation of these products? …

A great deal has changed since the 1990s in markets. They've grown far more global in nature. They've grown far more electronic, recalling that the Internet was not even a factor in the 1992 Presidential election and now in this last election so much was done on the Internet.

Well, that's true about markets as well. In the early- to even the mid-1990s, markets were either with people on the floor of the New York Stock Exchange or these markets would be with brokers and traders on telephones. So much has changed even in the products that were being issued. These markets in the 1990s were primarily -- if not almost exclusively -- helping manage risk in interest rates and currencies.

And in the last 5-or-8 years we had this new product called "credit default swaps" that so raised proportions that it brought down this large insurance company, AIG [American International Group].

How was Alan Greenspan viewed back then?

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He was the Chairman of the Federal Reserve. The Federal Reserve had done a great deal as a central bank to help promote a very strong economy. During the Clinton administration, 22 million jobs were created. We went from a period of deficits to surpluses. So I think that there is a very positive public and congressional feeling about the economic times and the economic stewardship. ...

What was the general attitude at that point about the role of the regulatory agencies, about what regulation was good or bad, when it was too much? …

Well, I can only speak to my view. My view is that the American public best benefits from a regulated market economy. There's 3 words there: "regulated market economy." President Franklin Delano Roosevelt recognized this in the 1930s when he called for Congress to adopt regulations to both regulate the securities markets and the commodities markets. That's when we ended up with the Securities and Exchange Commission -- something called the Commodities and Exchange Act that set up our agency subsequently.

And that's why I believe we need to do this in this derivatives marketplace -- the over-the-counter derivatives marketplace as well -- to bring greater transparency and lower risk in the markets today.

You ask about the 1990s. … Knowing what we know now, I believe we should have done more to protect the American public at that time through stronger, more vigorous regulation.

We did push for many things that were not achieved. We pushed for regulating derivative dealers, the big houses that deal in these products, that were affiliated with the Wall Street investment banks. That was not achievable at the time through the legislative process.

We pushed, in fact, along with the Department of Housing and Urban Development (HUD) ... to bring more rules of the road for selling mortgages to the American public -- particularly subprime mortgages. I personally testified on the Hill on this. It was not achievable through the legislative process at the time. But I think we should have pushed harder. I think we absolutely should have pushed harder to bring greater transparency and protect the public.

Brooksley Born becomes head of CFTC in 1996. She seemed to have a different point of view toward regulation than some of the other powers that be. What was your role at that point? You were at Treasury. Can you explain what your role was?

I was part of the Treasury group supporting the Secretary and the deputy secretary. I was an assistant secretary of the Treasury for financial markets. My primary role was helping to determine how we went from deficits to surplus -- and that we actually paid down the debt -- was what I spent a lot of time on. But I was also advising the Secretary and the deputy secretary with regard to capital markets. ...

How was it to work there? What was the feeling of where you guys were going, what you were doing, what your role was?

Secretary Robert Rubin was open to ideas and very inclusive throughout the building. He saw that we should be open and available to the White House when they had various policy debates that he wanted us to be supportive of and staffing them on various things. He's a very able leader who listened to all points of view, made sure that we ran a process that got outside points of view as well. ...

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CFTC at some point puts out a "concept release" [a report released to the public outlining a proposed rule change] asking multiple questions about how to deal with some of these markets. ...

It's a period of time I wasn't directly involved so I can't speak for the Department of Treasury. I was involved later. The Commodity Futures Trading Commission did not at that point in time regulate. Nor did any other regulator regulate these markets, here in the United States or in Europe.

The agency was raising very good questions at the time about these markets. ... The questions that we've raised now are well informed by reading the concept release that I went back to and read very closely and have kept by my side. ...

There was a debate ... in this period as to the outstanding contracts that were in this very complex marketplace and their legal enforceability. Under most interpretations of the laws, they were fully enforceable. But there was a modest, small risk as to whether they were enforceable. ...

In the over-the-counter derivatives marketplace -- which was not regulated by any U.S. regulator, European regulator or Asian regulator -- there were hundreds of thousands of contracts measured in the trillions of dollars. And most interpretations were they were all legally enforceable and they were good contracts. But there was a small uncertainty based upon how the statutory language was written as to their enforceability. And even a very small question that the lawyers were raising -- various lawyers in the markets and various lawyers in regulatory agencies -- was addressed by Congress later in a bill [Commodity Futures Modernization Act] that they passed in 2000. It seems now in hindsight a small issue. But that was what led to that legislation in 2000.

... Were we over concerned at that point? …

I think looking back now based on what we know now and how the markets have developed -- and a lot has changed since then in terms of the marketplace -- we should have done more to bring broad reform to this marketplace. The legislative initiative that occurred during that period of time did do some very good things. It for the first time brought forward in statute ways to do centralized clearing. And even today there's a big debate about centralized clearing. But for the first time we were able to do it in statute.

We did recommend to do more. We recommended to bring greater oversight to the derivative dealers affiliated with the Bear Stearns and Lehman Brothers and so forth. We were not able to achieve that in Congress. But we should have done more. We should have recommended really mandating a lot more reform in this area. I doubt -- if I might say -- that it would have gotten much legislative support given the times and given some of the particular leadership of the committees. But I still think knowing what we know now looking back, we should have done more.

Why was Born sort of onto this early? She was sort of a lonely voice. What was she worried about?

I think now being chairman of the Commodity Futures Trading Commission, there's a lot about … the expertise that this agency brings -- this is the one agency that oversees the derivatives marketplace, a slice of the derivatives marketplace we call futures, by statute we have exclusive jurisdiction over that. There's such a similarity between futures and swaps and they're sometimes almost indistinguishable. I think being chairman of this agency certainly informs me in terms of what I'm promoting. And would naturally inform any chairman, I would think.

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Being in the seat that you're in now, that Born was in at that point, is there a natural sort of feeling that this is a territory that you need to take care of because if you don't, no one else will?

I think this is a great agency. The people in this building are thinking nearly every day about the derivatives marketplace whether it's the derivatives marketplace we call "futures" or the derivatives marketplace we call "swaps" or over-the-counter derivatives. They're thinking about both.

And if I can just use a term -- the reason it's called "over the counter" is because it's not on an exchange. It's as if you walked into a store and you just personally bought something over the counter. In this case you go to a large Wall Street firm and do a transaction, currently not regulated. It wasn't regulated in the 1990s; it's not regulated now. We should regulate them.

What should be and should not be on the exchanges?

I believe strongly that we need 2 complementary regimes. We need to regulate the dealers -- these 20-or -30 large global financial firms that issue these derivatives. How should we regulate them? We should make sure there's a lot lower risk and we do that by capital and having margin requirements. Capital means money put to the side in case of crisis and so forth.

We're going to enhance the integrity of markets by business conduct standards, protecting the public against fraud and manipulation, and lastly promoting] transparency by record keeping and reporting. …

But I don't think that's enough. I think we also need to mandate that the standard product -- the product that can be put onto an exchange and put onto what's called centralized clearing -- be done.

Why is that? An exchange -- just like the New York Stock Exchange or the Chicago Board of Trade for agricultural commodities -- brings transparency. That means anyone in the public could know what the price is, what somebody is willing to buy or sell this risk contract for. And even though they're very complicated contracts, if it's a small hospital in your township, if it's a small school, or even a large business in your state, they could then look to this exchange and say: "This is where it's priced." They'd get the benefit of that.

Some people will argue -- and they argued back then -- that these deals are being done between two very savvy organizations. These are not private citizens; you don't need the government overview. Your point of view on that?

My point of view is that … these big institutions still would benefit and the public (300 million Americans) would benefit if we lowered the risk in this system and we add to transparency. Every end user, every institution -- even if they're big and savvy -- would benefit from knowing what some other institution just paid for just one of these things. We would promote economic activity, I believe, if we brought a lot of sunlight into this area. ...

Give us an understanding of what the Long-Term Capital Management hedge fund case was why it was considered to be such a serious event and how you got involved in it.

I joined the Department of Treasury in the fall of 1997. This was a period of time that many nations were having economic difficulty and difficulty paying their own debts -- Korea, Indonesia, Thailand; subsequently in 1998, Brazil, Russia. It's come to be called the emerging debt crisis or the emerging-market debt crisis. But what we know is there was a lot of uncertainty in capital markets and a lot of

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uncertainty as to whether this would come back and affect the American public and their pocketbooks and their jobs and their livelihoods.

In the fall of 1998, just around the period of time that Russia as a nation was about to default on their debt. And there was great uncertainty about Latin American debt. A hedge fund in Connecticut called Long-Term Capital Management went to the brink of its existence. ...

How did you hear about it? T ake us to that moment.

I was familiar with Long-Term Capital Management as an entity. It was one of the largest investment funds which we called hedge funds at the time. And it was run by very prominent individuals who once worked, I believe, at Salomon Brothers and elsewhere. So in my role as an assistant secretary for financial markets at the Treasury, we stayed abreast of some market dynamics.

But most particularly, I received a phone call. I was at home and I got a call as I would often get a call from the Treasury operator. And the Treasury operator said: "The Secretary is on the phone for you." It was Secretary Rubin on a Saturday. I even remember the call because my then 1-year-old was sitting on my lap trying to take the phone from me and the Secretary of the Treasury wants to have a conversation with me about this hedge fund that apparently was about to go under. So that's when I learned about it.

He shared some things with me over the phone that he had learned from the Federal Reserve,and shared with me that there were going to be some meetings the next day in Connecticut at Long-Term Capital Management.

As it developed, after that phone call I actually joined the Federal Reserve that Sunday in Connecticut.

How serious a problem was this viewed to be? Why was it a serious problem? What were the concerns about the reverberations through the system? ...

Long-Term Capital Management was a hedge fund that had a significant balance sheet. I think it was over $100 billion. But it also had very large positions in the over-the-counter derivatives marketplace. And if it came down, the question -- and all it was was a question -- is how would that affect the American public? How would that reverberate through the system and affect everybody's livelihood in the country?

So we were monitoring it. We went up to Connecticut that weekend. The Federal Reserve then took some steps to coordinate a private-sector solution. I mean, there was no government money that was put in, but a group of 10-or-12 private-sector institutions came to put some temporary money in Long-Term Capital to then wind it down.

There was a temporary solution to avoid the bankruptcy of Long-Term Capital Management which we thought would happen by that Wednesday. We thought maybe it was going to last 2-or-3 more days. And it was a question mark. Nobody really knows what would have happened if it went under. But the Federal Reserve of New York coordinated some meetings for a private-sector resolution and then Long-Term Capital Management was unwound over the next 18 months or 2 years.

And the lessons learned? I mean, there were a lot of people that were very concerned about this and thought that this did bring up some points that needed to be dealt with about

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regulation, about over-the-counter derivatives. What were the lessons learned -- or not understood well enough -- at that point?

I think there are many lessons learned from that circumstance then. And then, even looking back 11 years now, you can take them in the context of the crisis that we went through last year. But at the time, the lessons actually came together in a report of the President's Working Group that following spring. We felt that as a group -- and I helped to staff that report because it's a report of the Secretary of the Treasury and the head of the Federal Reserve -- some of the lessons included that we needed to do more to regulate these markets and that the private-sector firms also needed to do more around risk management, their risk with these entities.

I believe the report that following Fall was the first time we recommended greater oversight of derivative dealers which were affiliated with the Wall Street investment banks. It led to some of our recommendations later to have what's called centralized clearing of these derivatives.

But looking back 11 years later, I think there's additional lessons about some of the moral hazard -- what happens when government gets involved, even in a private-sector solution in the financial markets. ...

Did we miss something? Were there things that should have been learned from Long-Term Capital that were not learned?

I believe that looking back now, all of us -- with the lessons we have from the 11 years passed -- should have done more to protect the American public. Long-Term Capital Management was ... smaller ... than these large institutions, the AIGs and the Lehman Brothers and the Bear Stearns that brought the financial system to the precipice last Fall. But I do think that there are lessons from that period of time about what we have to do going forward now. We have to lower the risk in the system.

One of the big lessons from Long-Term Capital Management is also that we have to make the system less interconnected. We live in a system that's highly connected -- a global system. We all can go on the Internet and communicate with somebody in Malaysia or in France or buy products. But also the financial system is similarly connected. If one big institution is going to fail, tumble, it's so connected it might bring down the other institutions and bring down the American public. And I think that the great lesson we started to see in Long-Term Capital Management, it was rather interconnected even for a hedge fund.

I believe that's why we have to regulate derivatives now. We have to have these things called clearinghouses that help lower risk. They make the system less connected, these big financial institutions. I believe in a sense we need to be able to let the system be less connected and thus if one institution were to fail, less prone to hurt the American public. …

Some of the recommendations you made, why did they not happen?

Some of the recommendations were fully supported at Treasury and the CFTC but not necessarily at the other federal regulators. Some of the recommendations were supported by housing markets between HUD and Treasury but not necessarily at the Federal Reserve. I think that that was a challenge for us at the time. But also there were different times and different leadership of committees and different philosophies of the times.

So Congress was not totally onboard?

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There were many members of Congress that would be onboard. But it usually takes the leaders of relevant committees, too.

… What's your view of the 2000 CFMA [Commodity Futures Modernization Act]?

... The American system was regulating futures but not these other things, over-the-counter derivatives. We need to do that now. We need to regulate these over-the-counter derivatives. ...

I think we must do this now. I think there is the consensus among experts, among academics, and most importantly -- if I might say -- among political leadership here in Washington.

I do believe that some of the animal spirits are coming back, though, to Wall Street. And there's going to be those challenges that are inevitable in any public debate. That the big derivative dealers will raise questions about what we're saying because we're talking about regulating these big Wall Street institutions, and regulating them for more capital to lower risk. ... We're talking about greater transparency for the public. Again, these big Wall Street firms might have a little bit different point of view.

So I believe the consensus exists. I believe we must do this. But I recognize that there will be a debate from the other side.

And the people say that that other side is like 5 lobbyists for every congressman. It's a very difficult fight to fight when you've got the banking industry against you and there is a gathering steam here of a battle to come. What are the difficulties you must overcome to push forward with some of these regulations?

I think that it's a battle worth fighting and it's a battle to protect the American public, to bring greater transparency and lower risk. One of the challenges is this is a very complex, detailed World. So in discussing this with members of Congress, we have to bring to it -- as an Agency and as an Administration -- enough technical expertise so that we can help not only inform the public and inform Congress about these matters but also when somebody takes the opposing point of view, that we understand that point of view and we know how to sort through what sometimes is like a dust storm of complexity.

Why is this important?

It's very important because we can't let this happen again. … You could be living in Iowa as a farmer or you could be living in Maryland as a doctor and have no relationship with a company called AIG and wake up one day and $180 billion of your money -- this is the American public's money; this isn't Wall Street's money -- had to go into an insurance company that was so lightly regulated that the system might have come down if they failed.

How much of a factor was the era of deregulation that Alan Greenspan and others represented in causing the recent crisis?

I think there are many factors in this crisis. The financial system failed the American public. The financial regulatory system failed the American public. There were also imbalances. I mean, we as a nation were saving far too little and borrowing far too much. ...

With the current laws, you could have done so much more. That's why as chairman of the Commodity Futures Trading Commission, I'm not only asking Congress for these new authorities but I

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also believe in our current authorities. We have to use all our current authorities that we have. I'm not sure that the prior Administration had the same attitude about using all the current authorities that we have, as well as working to get new ones. ...

Looking back a lot of people will ask, what if Born had gotten her way? What's your view on that? ...

I believe there were many factors that led to this crisis: global imbalances; a regulatory culture of an administration; gaps in our regulatory system; mortgage sales practices that preyed upon the American public. I think all of us looking back think about this, and think, what could we have done more? If we could have done just any one of these factors, it certainly would have been helpful. But there was more than just one factor that, I believe, led to this crisis.

... Historically speaking, looking back, what do we take from this?

I take with it that we have to do more to protect the American public.

And as far as Brooksley [Born's] legacy?

I'm honored to be chairman of the Commodity Futures Trading Commission, to sit in the office that Chair Born sat in. I'm honored that she takes my calls and we talk and I can seek her advice. I think she has a great place in the history of this agency. ...

People say the CFTC is sort of a "backwater" ... regulatory agency. Does CFTC have the power, does it have the budget, does it have the ability to really oversee this very complicated and huge market?

Upon getting to the CFTC, I was delighted to find really terrific expert staff here, but not enough. During the prior Administration, this agency was shrunk over 20 percent. I mean, there's fewer people here now than in 1999 and the markets have grown 5-fold. So the markets are 5 times bigger and the place has one 1 of 5 people left. This math seems upside down to me.

So working with Congress, we need a lot more resources. But we do have the expertise; we just need more of it.

Analysis: More About Brooksley Bornby Manuel Roig-Franzia / The Washington Post

It begins with a father who wants a boy. She was born in San Francisco. Her father was a welfare agency executive for a long time and he thought it would be great to have a son. His best friend at the time was named Brooks and he thought: "I'll name my son Brooks." But he ended up with a girl and he named her Brooksley at the last minute, feminizing it.

And why is this significant at all? I think that as you look at the trajectory of Brooksley Born, you see a situation in which this woman is forever coming up against the question of her identity as a woman in a man's world.

She goes to Stanford. She attends the law school there. And on one of her first days, one of her male classmates comes up to her and says: "You are taking the place of a man who will surely be going to Vietnam and risking his life for America. You are taking his place. If you weren't here, he might not

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be over there risking his life." So can you imagine what that must have been like for a woman who was pushing up against some barriers?

She goes on to then be the first female president of the Law Review at Stanford. They have a vote and she's the obvious choice because she's first in her class. You would think this would be a great moment of triumph for Brooksley Born. Instead, she gets a phone call from one of the deans. She goes down to his office and he says: "Brooksley, I just want to let you know that the faculty stands ready to step in if you're not able to pull this off."

Can you imagine that? You're number one in your class. You're the first woman, ever, to be number one in your class! Interesting to note that there was another pretty smart, female law student that preceded her named Sandra Day O'Connor at Stanford University. But Brooksley Born was the first to be number one. …

She'll say that her response was "I don't plan to fail." It goes on like that, on and on and on at each step of Brooksley Born's life and career. …

What is her specialty in Law? What does she end up doing?

She ends up at Arnold & Porter, a prestigious law firm, and she begins representing futures exchanges including the London Futures Exchange, which is an important one.

She starts becoming an expert in an area of the law that very few people are experts in. And she gets involved in the 1980s in this really important headline-grabbing case of the manipulation of the silver market by these wealthy brothers, the Hunt brothers.

Wealthy Texas brothers, right?

Yes. And she was representing the clients of a Swiss bank who were being accused of being complicit in all of this. But through that process, she begins to understand how these markets work. And she gets to bore into a subject and gets sort of an insider's look at it because she's representing these people who had millions of dollars at stake that other lawyers who might just have a casual interaction with that world might never have gotten to glimpse.

It makes her skeptical of this really important notion. ... It's the question of sophisticated investors and can they be trusted to have their best interests at heart no matter what to prevent fraud and protect unsophisticated investors? The idea was that sophisticated investors would police themselves because they would need clean markets in order for things to function.

But what she learned through the silver case was that sophisticated investors could be duped just as easily as you and me.

Because greed overtakes and trumps any rationality, yes?

And perhaps also because when you're a sophisticated investor, you are involved in complex transactions that are, in some ways, more easy to manipulate than less complicated transactions.

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Nancy Duff Campbell / Washington attorney

At that time, there weren't very many women who even went to law school. I think she's told the story that she took some kind of an aptitude test to try to see what she was good for because that was sort of a traditional thing that happened then. And she liked to joke that the test itself, they had a certain test for women and a certain test for men and they were even pink and blue in their colors. I don't know if that's apocryphal or not. But that's what she jokes about.

And the idea was well, let's see if a woman should be a nurse or a teacher. It wasn't let's see if she should be a nurse or a teacher or a lawyer. I think either she or maybe her mother said: "Well, don't limit yourself to the test for women. Take the test for the men, too." And she did and apparently showed some aptitude for Law and decided then to go to Law school.

There were very few women in Law school at the time. Stanford had one of the larger classes, maybe 10 percent. So the first thing was just going to Law school and being in a very limited group of women.

And then, this was during the Vietnam War. I know that she's described her experience -- which is similar to one that occurred when I went to Law school a few years later -- that a lot of men in the class were saying "What are you doing here? You're taking the place of somebody, a man who could be here and not have to go to the war" because at that time, there were graduate deferments.

And I know that Brooksley -- again, this is a mark of her excellence -- the way she approached this was: "Well, I'd better do really well because I've got a coveted place. And I've got to show them I can do it."

And she did.

She graduated at the top of her class. …

What drove her?

I think that she had a lot of internal drive, if I can extrapolate. Of course, I didn't know her then. I think that her parents were very encouraging just as the story of her mother and the test illustrates. And I think she had a lot of self-confidence that has carried her well throughout her career and that made her want to do well then and do well thereafter. …

She's interested, afterwards, in possibly clerking for the Supreme Court?

One of the marks of a path to success after law school is to clerk for a judge. Usually a Federal judge if you can and, of course, a Supreme Court justice if you can. But at that time, again, many judges just didn't pick women. They didn't think twice about saying "Well, I don't take women as clerks." ...

So she comes to Washington. She likes it. What happens next?

Yeah, she came to Washington and clerked for a Federal judge. And ... she kind of got the policy bug and saw that it was a very exciting place to be a lawyer in Washington. She'd seen very interesting cases in her court experience. And so she decided that she wanted to stay in Washington and to practice here.

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I think she was committed from the beginning not only to be excellent. But to be excellent in a way that would make a difference for people.

Michael GreenbergerDirector, CTFC Division of Trading and Markets (1997-1999)

She had developed a very close relationship with Hillary Clinton when Hillary Clinton was a very prominent lawyer in Little Rock, Ark. ... When Clinton got elected, I remembered hearing the story that Mrs. Clinton and Clinton and a group were bandying about who would be the Attorney General and somebody said: "Well, Brooksley Born would be a good attorney general." ... And Brooksley went in for an interview with Clinton. The story comes back was that Clinton found her boring and that it never went anywhere. ...

I think to some extent you could view this position as head of the CFTC as a consolation prize. ... To the general world, people who knew Brooksley, the circles she traveled, the American Bar Association, the D.C. Bar, and all the prestigious boards she served on, people were probably scratching their heads.

Joe Nocera / The New York Times

When she first gets the job, she gets invited to lunch with Fed Chairman Alan Greenspan and they talk about fraud. Do you remember the story?

It's actually becoming a somewhat famous story. This was only the third time they met and she is still fairly new on the job. She said that he said something to the effect that "Well Brooksley, we are never going to agree on fraud." And she said: "Well, what do you mean?" And he said: "You probably think there should be rules against it." And she said: "Well, yes I do."

He said: "I think the market will figure it out and take care of the fraudsters." That is kind of an exaggerated view of the way he thought about markets -- the markets were self-correcting; markets could root out problems; markets would sort of shame the bad guys and help the good guys because bad guys would be ostracized by other market participants.

Sheila Bair Chair, Federal Deposit Insurance Corporation (2006-Present)

I had left the CFTC by the time she became chairman. But I was working at the New York Stock Exchange and just made her acquaintance. … We just connected. I think she wanted to hear some of my thoughts on some of these issues that we'd already been grappling with. …

So I was very impressed with her. I thought she was independent. She did believe in regulation and that value could come of regulation. And I think she wanted to do the right thing from a policy basis on these instruments and did see some of the growing risks.

So I think I was really not in a position to be very much help to her at that point other than to talk and provide moral support perhaps. But I do think that she did accurately identify the burgeoning risks that were growing and had become more profound since when I had been at the CFTC. But she was facing a very difficult industry resistance. …

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Her view of the role that CFTC should play merged to some extent with your view?

Yeah, I think so. I think she was just trying to bring some semblance of oversight to some of these markets. I think, unfairly, people tried to paint her position as more extreme than that. Like she was trying to force everything onto regulated futures exchanges. That's not what she was trying to do.

She was just trying to provide some common-sense overlay of supervision to these growing markets, these very internationally active markets, these very large markets.

But there was a very strong view in the industry among the major players in the swap market to not have any regulation. That had been religion with them for years -- i.e., keep the CFTC out of this as much as they can. And I think they had … successfully persuaded the Treasury and the Fed that the CFTC was overstepping itself and this was just a power grab, a turf battle. …

How difficult was it at that point for a woman to rise up in the levels of government, especially when it came to Wall Street issues?

That's a good question. I don't know. Certainly this is a heavily male-dominated culture and derivatives are a relatively recent innovation. Maybe a little bit more of a "cowboy culture" than other more established, regulated parts of the industry.

So that may have been an undercurrent, making that difficult situation even more difficult in terms of advocating and persuading others to her point of view.

David WesselThe Wall Street Journal and author of In Fed We Trust

Treasury Secretaries Robert Rubin, Larry Summers, and Greenspan had a great deal of faith in their own intellects. And I think that they were not welcoming of somebody who looked at the World differently and was kind of abrasive.

There probably were some issues of gender there. You may remember that there was also tension with former EPA head Carol Browner who was doing environmental stuff. So I think that no matter what the merits, there was bound to be some resistance. …

The system wasn't set up to allow somebody like Brooksley Born to have a real impact. And she didn't do it in a way that was likely to maximize her chances of getting Greenspan and Rubin and Summers to listen to her.

What does that mean?

A lot in public and a frontal assault on their intelligence and on what they were doing. In a sense, Joe Stiglitz has had similar issues. I mean, here's a guy who's a genius, … who won a Nobel Prize for identifying a situation where markets don't work just right.

But he seems to be better at calling attention to these things than actually finding a way to get a government to actually do something about them.

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The most successful people in these jobs have 2 characteristics: One, like Brooksley Born, they spot something that needs to be addressed. And two, they figure out some way to get it addressed. And the one is necessary but it's not sufficient.

And so, if you really want to judge somebody as a regulator or as a politician, it's about seeing things and getting them done.

Why does Teddy Kennedy have such a great reputation in Washington? It's because on the one hand, he gives a great speech; he's a lion of the left; he's a real progressive; he stands for things. And he manages to get bills through Congress.

Well, Brooksley Born was no Teddy Kennedy. That's just a fact. They don't often come in the same package. People who see things that other people don't see don't tend to be the people who are best at getting consensus.

Arthur LevittChair, Securities & Exchange Commission (1993-2001)

… I didn't know Brooksley Born. I was told about Brooksley Born. I was told that she was irascible, difficult, stubborn, unreasonable. But I've come to know her as one of the most capable, dedicated, intelligent and committed public servants that I have ever come to know. I wish I knew her better in Washington. And I wish my view of her was more rounded by personal exposure. ...

In my life I've had so many occasions of finding my impressions were incorrect and revising them, depending upon the circumstances, depending upon what stage of life I happen to be or what other factors were bearing on it. …

I've got to say to you that I have just huge affection and admiration and trust in Brooksley Born.

Based on?

Based on seeing a good deal of her in recent months, in talking to her about what I regard to have been a bad judgment that I made during that period when she was urging the President's Working Group to allow her to regulate swaps. You tend to gain some perspective when you recognize that you might have made a mistake.

Analysis: The Alan Greenspan EraArthur Levitt

Chair, Securities & Exchange Commission (1993-2001)

… Alan is a good friend and I knew him before I came to Washington and knew him well when he was there. We played golf and tennis together; we saw a good deal of one another.

He was probably the most highly respected and most revered person in the city at that time. He was more than an economist. He is a very broad-gauged individual with large numbers of friends and a tremendous following in Congress where people hung on every word -- most of which they didn't understand. But because it was Alan, they thought it was great.

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Now keep in mind, I have a theory about these government jobs whether it be chairman of the Federal Reserve or head of the SEC or the FTC [Federal Trade Commission] -- to some extent, the "Wizard of Oz" jobs. It's not the rules; it's not the regulations -- it's what they say. It's the issues they stake out and how they come across.

Alan was a great wizard. No one understood what he said. But he said it in such a way that everybody bought it. Everybody hung on every word and he was a good enough politician that he had great respect on both sides of the aisle. Very few people wanted to take him on or challenge him because he knew so much more than they did. And if he didn't, he certainly appeared to.

In a nutshell, what was his economic philosophy?

It's been reported pretty broadly that Alan was a laissez-faire, Ayn Rand, free-market economist. I think that's simplistic. He was much more than that. He was thoughtful, careful, measured, not at all impulsive, very traditional, and pretty set in his ways. …

... As the 2000s are going along and 9/11 has happened and other things start to happen, what's he doing? What's he worrying about?

I think Alan worried about the markets all the time. Alan cared passionately about U.S. markets, probably knew more about them than anyone in the history of the Country. Was extremely thoughtful, sensitive, intelligent. Was not close-minded, was open to hearing presentations. He was firm in his philosophy and we certainly differed in a number of respects. But I would have to say that I regard Alan Greenspan as one of the greatest public servants in modern history in spite of what some regard as his failure to anticipate the problems in an overleveraged environment. We were lucky to have him as chairman of the Fed.

He didn't seem to be concerned about where's the regulation, how do we manage this bubble?

I would say that more often than not, I had to prove to Alan why this regulation or that regulation made sense. I've always regarded the Federal Reserve as being the banker's protective association -- more concerned with safety and soundness than investor protection.

My obsession was investor protection. I couldn't care less about safety and soundness. That was part of the system. But if you don't have the confidence of investors, if you don't have the protections that are offered by private rights of action and the enforcement activities of the SEC, you have a universe of investors that don't trust. And we can't have markets that aren't trustworthy.

After the 2008 meltdown last fall when he sits before Congress, ... it's got to be an incredibly painful moment for him, that sort of mea culpa moment. What did you think when you saw that happening to him?

I thought that this is a stand-up guy that is realistic; that knows that life in Washington places people at the mercy of factors that are very often beyond their control; that good markets made all of us in that era look smarter than we really were. And when things change, we pay a price for that.

I think all of us who went through this period all made mistakes and wish that we had done some things differently. I don't think there's anybody who's served more than a year-or-so in Washington that wouldn't say the same thing.

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David WesselThe Wall Street Journal and author of In Fed We Trust

The chairman of the Federal Reserve has an enormous amount of power that comes with the job -- the power, of course, to move interest rates in one way or another that affect how the American economy works, in terms of how much we have to pay to borrow, how much businesses pay to borrow, how much we make on our savings, and all that stuff.

But Greenspan's power in the 1990s and early 2000s went far beyond the tools that just happened to come with the job. He was the wise man. He was the one who members of Congress sought out at hearings for his blessing about their particular proposal about taxes.

He was the one to whom Bill Clinton went very early in his tenure to validate his deficit-reduction plan and to sort of assure the world that Bill Clinton was of sound mind and could actually manage the U.S. economy.

And Greenspan had a very clear -- he was not at all secretive about it -- ideology about regulation. He really didn't think that regulators could do very much to stop people from doing what they were going to do anyway. He thought that he would cite his experience on the board of JPMorgan as evidence that the banks knew a lot more than the bank examiners would ever know. And that the best thing that could happen would be to let the banks and other big investors who had a lot of money in the game police the poker table.

His view was that they were sophisticated. They had a lot at stake and if things were going wrong, it would be in their interest to do something about it.

I thought one of the most fascinating moments of the recent period is when Greenspan goes before Rep. Henry Waxman's [D-Calif.] committee and Waxman asks him "Was your worldview wrong?" And Greenspan says yes, that it turns out that sophisticated money investors do not always do what is in their interest or in the interest of the system.

I think that confession tells you almost everything you need to know about what he got wrong in the '90s.

What must that have been like for him that day? …

I think it was pretty difficult. Let's remember when Alan Greenspan left office at the beginning of 2006, he was -- as George Bush put it at the time -- a "rock star". He had served 4 presidents. He was seen as almost a miracle worker. The American economy had had some of its best years under his tenure even though it had had to undergo the shocks of a stock market crash, a terrorist attack, a couple of wars, a presidential election that almost challenged the foundations of our democratic legitimacy.

Through all that, we had extraordinary growth. We had waning unemployment. We had not much inflation. And we had this great technology boom that he had foreseen -- the Internet and all -- that would help increase productivity so the economy should grow stronger.

So he was celebrated in a way that we hadn't seen before in someone who had a job like the chairman of the Federal Reserve. Remember, his predecessor Paul Volcker had been pilloried for putting the economy through a wrenching recession to break the back of inflation. Greenspan was the one who brought us the New Economy. Everything was going to be wonderful. It was never going to rain again in America.

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And so when he retired, he had become almost papal-like in his infallibility. And then soon after he leaves office, the whole thing falls apart and the book -- I think it's kind of funny. He wrote a book about his time called The Age of Turbulence as if he had presided over a turbulent age, the end of the Cold War, the changes in the world economy. But the age of turbulence really began after he left.

So I think he went from being a hero to being a villain, probably.

I think he believes -- and I think he's right -- he got more credit for the good times and more blame for the bad times than he deserves. And that hearing before Henry Waxman was kind of his way of saying to people "I recognize I got it wrong", which is not something that comes easily to him. …

… How much of what actually happened rests at his feet?

I think it's wrong to say that one person is responsible for the worst calamity to hit the U.S. economy since the Great Depression itself. What makes it extraordinary is the number of people and institutions that failed. …

But if you were making the list, the 10-or-12 things that accounted for this, you'd have to put the Federal Reserve and Alan Greenspan on the list. There are people who say with hindsight -- and I think that's important -- that he kept interest rates too low too long and that encouraged this borrowing and speculation.

I think that's probably right, but only with hindsight. There are people who say -- and I think they have a much stronger case -- that he did not use his regulatory powers in ways that, in retrospect, were prudent. And there was some evidence at the time that there was some need for that.

I think that his approach to regulation -- his ideology, if you will -- held him back. A different Federal Reserve chairman -- perhaps even the current one Ben Bernanke -- might have been more aggressive on that. …

He had this really interesting metaphor which was the economy was like a very big and sophisticated airplane. And in the old days, the airplanes would shake a lot. But then they got modern electronics and the modern electronics would compensate for the turbulence. So the plane would shake less because these very sophisticated electronics would absorb the turbulence.

And in his mind, the real Economy -- the one where we all live and work -- was like the airplane and the financial markets were the sophisticated electronics. So there would be a lot of volatility sometimes in financial markets and there would be all these sophisticated instruments -- in the case of the financial system, these derivatives and stuff -- and they would be absorbing the risk so the economy could be more stable.

And you know, it made a lot of sense because one of the things that distinguished the economy of the 1990s and the 2000s was the economy itself was pretty stable. It was called by some economists "the great moderation." We didn't have the big booms and busts of inflation and then higher interest rates and then recession that had marked earlier periods in American history.

So he believed -- and he convinced a lot of other people -- that the financial system was helping to stabilize the real economy. And if you messed with it, you would have more turbulence in the real economy.

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Joseph StiglitzCouncil of Economic Advisers (1993-1997)

Greenspan, remember, always said that he was a believer in Ayn Rand -- a believer in free market. Little bit curious for a central banker because what is central banking? It's a massive intervention in the market, setting interest rates. So to me, that kind of perspective to say "I believe in free markets but I'm going to accept the job at central banking" is a contradiction. You almost have to be schizophrenic.

The question is what should be the interventions in the market? And we know we want some regulation -- how far do we go? And over the years, there's been a well-developed theory about when markets fail. We have a long historical experience and lots of economic theory.

Interestingly, some of the economic theory that was developed in the last quarter century -- my own work talking about what happens when there is imperfect information, which is, of course, at the centerpiece of financial markets -- explains that the reason that the invisible hand seems invisible so often is that it's not there. Markets are often not efficient. We can identify the nature of those failures -- not perfectly but we can -- and say "These are the instances in which we need government intervention."

And I think that many of these protagonists didn't really understand those basic economic ideas. They were wedded to, you might say, the outmoded ideas of free-market economics which assume perfect information, perfect competition, perfect markets, perfectly informed market participants, no exploitation -- all assumptions that are totally irrelevant to a complex modern economy.

But it looked to them as at first the tech bubble and then the housing bubble grew with relatively little -- from their point of view -- Government intervention. That in fact there was an invisible hand and it was all good and it was guiding us along, yes?

If they had thought about it for a minute, they would have realized that the visible hand of the Government had been there over-and-over again.

Just think about what the banks had done abroad. They had repeatedly, repeatedly viewed bubbles, misallocated capital, and government -- U.S. Treasury, IMF -- had repeatedly come and rescued them. We had the Latin America crisis at the beginning of the 1980s involving almost every Latin American country. We had the Mexican crisis in 1994-95. We had the Korean crisis, the Indonesian crisis, the Thai crisis in 1997. We then had the Russian crisis and the Brazilian crisis in 1998. We had the Argentina crisis. The list is long involving hundreds of billions of dollars, again, in government intervention.

So yes, the economy did work. But it was because the Government kept bailing it out. It kept bailing out the financial sector. So they made a fundamental misinterpretation. ...

In the Gall after the meltdown, Alan Greenspan goes before the Congress and he does a sort of mea culpa. What did you make of that?

I think it was a moment of honesty. I think he had genuinely believed in self-regulation which I view as an oxymoron. Now as an economist, we realized that the whole notion of self-regulation was an absurdity because one of the reasons for regulation is what we call externalities. A failure in a bank or a failure of the financial system has an effect on everybody. And the bank is looking only at its direct cost and benefits, not on the cost on the rest of our society. And it's those external effects that provide the motivation for government regulation. ...

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He didn't admit to that problem. But what he did admit to is he thought that at least the bankers would have enough rationality that they would look after their self-interest; that they would not engage in excessive risk taking to the point that they would put their shareholders and bondholders in jeopardy. But to me, if you look at the incentive structures that were confronting the managers of these banks, they had incentive structures that encouraged excessive risk taking and shortsighted behavior. ...

Do you think it was hard for Greenspan to say that?

Yes I do because it was so much part of his mind-set and his conviction. I think Greenspan was honestly doing what he thought was best for the economy for a long period of time. He was a public servant and we should never forget that. For 18 years, he worked very hard night and day for what he thought was in the interest of the American people. And he did this, I think, with a particular mind-set and talking to a particular group of people that helped shape that mind-set with a particular set of beliefs. He could have gotten a lot more money if he had been in the private sector. So he really did sacrifice a great deal to pursue what he thought was in the public interest. ...

Mark BrickellChair, International Swaps and Derivatives Association (1988-1992)

What did Greenspan think of derivatives?

We can go to the public record to answer that question. He had said that he perceived derivatives to be one of the greatest innovations in recent financial history. That the contracts -- because they helped businesses and banks and governments manage the risks to which they were already exposed more efficiently than they could have done before -- were doing something that was useful for the financial system.

And to see that business -- which had grown up inside the banking system. jeopardized by the creation of legal uncertainty where it hadn't existed before -- would have elicited a strong reaction from anyone who understood the business and the banking system as well as he did. …

Michael GreenbergerDirector, CTFC Division of Trading and Markets (1997-1999)

When I went to work with Brooksley Born and she was telling me "This is what you're up against," she told me that she had had this lunch with Alan Greenspan and he had said to her probably that she and he were going to have a disagreement about something and the subject was fraud. And he didn't believe that fraud was something that needed to be enforced or was something that regulators should worry about but he assumed she probably did. And of course she did. I've never met a financial regulator who didn't feel that fraud was part of their mission,. Bt that was her introduction to Alan Greenspan.

What does it tell you -- what did it tell her -- that he didn't believe fraud was a problem?

From what it told her and from what I could see in my observations of Alan Greenspan was that this was a man who was living almost in another era. That he was a total believer that the markets were self-correcting. For example, the reason he thought that fraud shouldn't be the worry of regulators is, well if somebody committed fraud in the business community, the rational workings of the market would be

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that people wouldn't do business with that person and therefore they would die on the vine. And so the free market self-corrects and takes care of fraudulent actors. ...

... Is there something about him by then? Is he just untouchable?

Yes. Look, the economy by and large in this period is booming. There are hiccups. You have the Asian financial crisis, the default on the Russian ruble. Later on, you have the Long-Term Capital Management fiasco. But basically it's an upward move. We're in the middle of the dot-com bubble. ... He is a force to contend with. He's very, very highly regarded although there's an understanding that he's coming at issues from a very orthodox free-market view and he's not happy with the regulatory structure. He's tolerating it. But he's not happy about it.

Roger LowensteinAuthor of When Genius Failed

Alan Greenspan was a financial consultant who was hired by Jerry Ford, first to be head of his Council of Economic Advisers in the 1970s. ...

He did a very good job chairing the Social Security commission for Ronald Reagan and brought together disparate points of views and got some changes there.

And so he's picked as Fed chief. And he's a Fed chief unlike, say, Paul Volcker who preceded him and who didn't have a particular ideology. ... Greenspan had an ideology which is along the lines of Ronald Reagan -- less regulation, less government, more markets.

And in particular when he saw these innovative instruments in markets, derivatives, he really got kind of weak-kneed for them. … He had a great love and respect for -- and maybe infatuation with -- the powers of free-market innovation. …

… Arthur Levitt said: "He was the wizard. And he was the best wizard I ever saw." In what sense?

He was unintelligible. … It was almost a joke the way he would speak. It was so imponderable, the sentence constructions. … He so qualified everything. The circumlocutions were so complex that you couldn't understand practically what he was saying. And you know, people tend to think: "Wow, I can't understand him. He must be smart." And he is smart.

If you read his memoirs, they're engaging and surprisingly plainspoken, pleasingly so. But that was not how he was. So that was one element of his wizardly-ness.

He was very willing to go with arcane data, indicators that hadn't been widely watched. He was very willing to say "In the bad old days of high inflation, people were very afraid to let the unemployment rate get too low." You didn't mishear me. I mean, to most of us unemployment is a bad thing. Low unemployment is a good thing. But not for central bankers because they're worried if unemployment was too low, companies would have to pay too much for labor and then inflation would go up.

And Greenspan would say, you know, maybe we can let this ride a little more. Just because more people are getting work, nothing bad is happening and maybe the economy is so productive that it won't result in price increases. And that basically happened.

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The simplest answer for why he was viewed as an "oracle "is if you take the period. He came in right before the market crash of 1987. Of course, that was a rough start. But they managed through it. From that point on, markets had a 12-year glorious run, really, around the World. Equity markets went up. Interest rates went down. Inflation went down.

So chicken and egg. Did Greenspan cause it? Are we right to call him a wizard? Or was he running the ship in a buoyant period? I'm sure it's some of each. But good things were happening around the World. …

If one crossed him, how could he be?

I can't answer that.

Nobody crossed him?

People were intimidated by him. The Fed is a collegial, a consensual body. The governors are equal in terms of their votes -- something like the Supreme Court where there's a chief justice, but they all get one vote and everything. And the interest-rate moves are supposed to be dictated by the group.

However, that really, really was a truth that described a larger fiction because it became Greenspan's Fed. And nobody did cross him. Nobody really disagreed with him. But very occasionally he would get one vote the other way, almost a show. But I don't think ever two.

And there was no doubt who was maneuvering interest rates. It wasn't the Board of Governors. It was the governor. It was Alan.

Analysis: Why Derivatives Were Created and What Went Wrong

Marck BrickellChair, International Swaps and Derivatives Association (1988-1992)

Every business faces risk when it opens its doors. If you're running an automobile manufacturing company and you borrow money at a floating rate of interest in U.S. dollars, you're at risk if interest rates rise because your borrowing costs will increase.

But you're at risk indirectly, exposed to other kinds of financial risks indirectly as well. … The U.S. automaker who competes with Japanese firms is hurt when the yen declines in value against the dollar because that allows the Japanese car manufacturer to sell his cars more cheaply in this country.

Now those risks exist in the economy before derivatives appear on the scene. And what the derivatives do -- and the policy-makers understand this -- is they allow parties, companies, financial institutions, governments, to shed the risks that they don't want to take and take on other risks that they would prefer to be exposed to. And managing risk is a big part of business. It's part of managing financial institutions; it's part of government.

So the innovative element of swaps is that they allow people to manage the risks to which they're already exposed at a lower cost more efficiently than they were able to manage them before derivatives came on the scene. …

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There are series of epiphanies as you realize we could manage commodity price risk, equity price risk, the risk of changes in weather, the risk of changes in the credit quality of a borrower, by using these same techniques. And as we apply the risk-management approach to more and more kinds of risk, the business grows.

That's how the business has grown from nothing in 1980 to $600 trillion of contracts today.

Henry KaufmanDirector, Lehman Brothers (1995-2008) and author of The Road to Financial Reformation

When I was at Salomon Brothers in the senior management, we were really the innovators of the interest-rate swap. … It was a simple thing. We were a broker. We put someone who wanted a fixed rate versus someone who was willing to pay a floating rate and we took a fee for putting those two participants together.

Not much later on after we started this, we were willing to do this as a dealer and take the risk in between. And we did it for relatively short maturities. I remember sitting in our executive committee meeting and a group run by bond trader John Meriwether who came in and wanted a larger amount to position and with short maturities. We gave them a larger amount to position in our portfolio, as inventory.

And then he wanted a larger amount. Then he wanted to do longer maturities and somewhat more complicated interest rate swaps. And other things came along. And then after a while, those positions became so big that you had to be very careful as to the risk you were taking or positioning in government securities, in corporate obligations, and so on. You could just go so much before you might have had problems with your lenders.

It was kind of a nifty business because you could do a relatively large volume of business with a moderate amount of overhead and secure a very significant profit. And that was very enticing.

It became a big wholesaling operation after a while. So, this took over with credit default swaps which JPMorgan went into,and so on in the 1990s and drove very hard.

When you saw the evolution take place and it becomes slicing and dicing them, handing them to AIG, what were you thinking? What were you worried about?

My concern about all of this was -- even in the days of Salomon when I was on the executive committee -- how big do you want to be in this? How far a position do you want to take? How much do you want to dominate the market in this? And what will it do to other activities that you were involved in? How much risk do you want to take in total?

And there never seemed to be a ceiling in the process. There was always another form of derivative that you could create and another way of laying off a little bit of the risk and so on. Just like, for example, Goldman Sachs laid off some of the risk with AIG. There was always another way of diminishing the so-called risk taking.

It was very difficult for participants to realize the totality of this risk taking in the system. And the central bank didn't realize it. Either didn't realize it, didn't want to realize it, or didn't have the capacity to realize it. That, I think, was part of my concern.

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Blythe MastersCFO, JPMorgan; in 1997, she was part of a group at JPMorgan who created credit derivatives

Let's take Exxon as a case. You were involved directly in that idea; that was one of the first credit derivatives. ... Walk me through it.

Exxon was the client at the bank and we had credit exposure associated with that relationship in conjunction with a letter of credit that had been issued by JPMorgan on behalf of the company. A letter of credit creates credit risk. If Exxon were to fail on their obligations, then JPMorgan would have to step in and make good on those obligations on their behalf. It was a large amount of exposure and there was a significant amount of risk associated with that.

The idea was that we wished to purchase protection from others. In this case, the example that was made public was from the EBRD which is the European Bank for Reconstruction and Development. And so we paid them a fee in return for their assuming the credit riskiness of Exxon, in this case. And that was it, a very simple concept.

Why did JPMorgan do that? Because we wanted to free up our capacity to do more business for Exxon. Why did EBRD do that? Because they felt that Exxon was a strong company whose business model they understood. I believe it was AAA rated at the time. They would receive compensation from JPMorgan from taking on or assuming credit risk to Exxon and felt that that was a good risk/reward proposition.

They took on a modest amount of risk; we reduced our risk. They didn't create a significant concentration in their case and so risk was essentially dispersed.

And if you imagine that example multiplied by hundreds of different examples, you can see how concentrated risks on the balance sheet of one bank -- in this case JPMorgan -- begin to make their way into the hands of investors at prices that those investors are comfortable with and pleased with.

And in many cases, this represents credit risk that those investors could not themselves have originated directly. Exxon was not issuing large amounts of corporate debt at the time. So the existence of this letter of credit -- which was a bank market product -- meant that that credit asset, if you will, was really not available to an institutional investor like the EBRD was at the time.

In that deal, how did JPMorgan make money?

In that particular example, it would have been essentially between the price at which we originated the credit and the price at which we laid it off.

Or alternatively, imagine that that was a flat proposition -- meaning that they were the same prices. The opportunity that was created was the opportunity to do more business with our customer and to get paid by the fees associated with that incremental business. Had we not laid off this risk, we would have been full up with that credit risk and unable to do more business. So the future revenue-generating opportunity would have been curtailed.

… How does EBRD make their money?

They're acting as an investor. They have an investment portfolio. In their case, they had at the time various restrictions in terms of the nature of credit risk that they were permitted to take on. In particular, they were required to meet a very high credit standard. So, access to an AAA corporate that was not

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active in the corporate debt market, did not have a lot of public debt outstanding, was a unique opportunity for them. Also at an attractive price.

So their job was to, for a living, take credit risk, to make investments. But they were constrained as to the availability as to what they could do. There wasn't another way to take on Exxon credit risk in this form at the time. So that was the opportunity for them. They had capital to deploy. If they didn't deploy it, they'd earn no return on it. …

Importantly, they made the decision as to whether-or-not they were comfortable at this pricing with Exxon's credit risk because they're a major sophisticated institutional investor in this context. That wasn't an act of persuasion on JPMorgan's part. What we were providing them was a means to an end where the end was defined by them. Their end was they had an investment objective and we achieved it for them. …

Were you worried about the potential for harm in those early days? Could you project out that Jeez! in the hands of others and securitizing the wrong stuff, this could be a problem?

No. And I think the most important way to understand why that's the case is if you look back through history and look at mishaps in financial markets, many of them have at their root credit-origination standards slipping for some reason or another. So lending in the Latin American debt markets, or crisis in the oil patch, the bursting of the tech bubble -- many of these events have had to do with the deployment of leverage, excess leverage, and the decline of risk-management standards often associated with competitive pressure.

Credit derivatives per se didn't change any of that. It didn't increase or reduce the propensity for people to make unwise, underlying credit decisions. Or at least that was the thinking at the time. It was really more that you created a transparent pricing mechanism for credit risk and filled the void rather than it really influenced the propensity of people to make unwise lending decisions in the first place. Obviously, subsequently some of that evolved along a different path. And that proved to be wrong.

Timothy O'Brien /The New York Times

Derivatives -- particularly because of the current meltdown -- have become demonized. They're seen as sort of Satan's little plaything.

But it's really important to remember that there are a lot of good, practical uses for derivatives. In fact, the average person who's a homeowner owns a derivative. It's the insurance policy on their house. It's essentially a contract that you enter into with an insurer that pays you a certain amount of money if some kind of damage or calamity happens to your home. And you pay a little bit of money -- or a lot of money depending on the size of your home -- each year for that policy.

Wall Street has all sorts of contracts like this. Derivatives, in essence, are insurance policies that various players on Wall Street and in the business world enter into to protect themselves from unforeseen calamities whether it's wild interest-rate swings, changes in the values of currencies, someone's debt going bad. …

And that's a good thing. When people have protection from things they can't control, it enables them to take sensible risks which allows them to grow their business and allows more money to get created and creates jobs. These are all good things as long as that's what these things are being used for.

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The problem is that no one really knows exactly what derivatives are being used for because it all exists in a black box. They're unregulated; the contracts aren't traded on exchanges; they're entered into between private parties. No one knows whether-or-not one company -- let's, for example, call them AIG, a big insurance company -- has entered into so many of these contracts that if an unforeseen financial hurricane comes and hits the house known as Wall Street and suddenly AIG is required to make good on … So many of these policies that they don't have enough money to do this and they run into danger of going belly up. Which is exactly what happened at AIG.

The only way you can get a handle on what the nature of the derivatives market is and whether-or-not some of the players are taking on more than they can swallow is if you have transparency. And we have not had transparency in the derivatives market for a very long time.

And the reason for that is?

I think one of the reasons is because the people who write derivatives contracts make a lot of money off of it. And you make more money off something that people can't comparison shop for. It's just like a car dealership. If you go in there and you know what the Blue Book value of the car is, you're in a strong negotiating position with the dealer. If you don't, you're a little bit at his mercy in terms of what the right price for the car is.

Same thing with derivatives. Someone's selling these things, has an interest in there being less open information about them because they get a bigger fee for it, and they can control the pricing in a better way.

Joseph StiglitzCouncil of Economic Advisers (1993-1997)

The derivatives were a major source of revenues for a few big banks. And those who were making lots of money out of it obviously wanted to continue with the source of money.

You have to ask the question did the Economy really grow so poorly in the decades before we invented derivatives? Answer: We did actually pretty well. We did better in that quarter century after World War II before we had derivatives than we've done since then.

You have to ask the question what are financial markets supposed to do? They're supposed to allocate capital; they're supposed to manage risk; they're supposed to do this all at low transaction costs.

In retrospect, we can see that our financial markets misallocated capital, mismanaged risk, created risk, and did it all at high transaction costs. It's very clear that they were involved in trying to maximize transaction costs. That's their revenues; that's their profits. Some of the innovations in risk management had the potential of enabling firms to undertake more risk than they otherwise would have by shifting the risk off to others. And that would have facilitated the growth of the real sector of our economy.

On the other hand, these derivatives are instruments for gambling -- non-transparent, difficult to see what's going on. And in that case, they are increasing risk, diverting attention from the real functions of the financial markets, and leading to poor performance of the Economy.

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Without regulation, you're going to wind up with the negative aspects of derivatives and not the positive aspects. And that's precisely what happened. So while they were a potential instrument for improving financial markets, if they are not used correctly, they are a potential -- as somebody said -- weapon of mass financial destruction. And that's what they turned out to be. …

Let me give you another example of the lack of transparency so not transparent that the financial institutions themselves didn't know what was going on. And if they didn't know what was going on, how can ordinary investors know what's going on? How can the regulators know what's going on? How can we have a well-functioning financial system?

The financial institutions that were creating these derivatives, these gambles, they would bet this bank would go down. "I'll bet you so much, a couple billion dollars." And then they would change their mind and say, "No, no, let's cancel that bet." But rather than cancel the bet, the other party would make a bet going the other direction. So if I bet you $10 and you bet me $10, the net is zero. That's how you got these gross numbers that were in the trillions. They said, "Don't worry; these net out." That's true except if one thing happens. If one of the two parties goes bankrupt. If A owes B and B owes A but A goes bankrupt, then A doesn't owe B but B still owes A. They don't net out.

If you ask them, they would have said: "Who could believe that any of them would go bankrupt? These are the biggest companies in the world -- AIG, the biggest insurance company in the world." But then you ask, what were they betting? They were betting on the demise of each of these companies. That's what the market was. So they at the same time said it would never happen and yet the market was bets about that it did happen. Total schizophrenia.

Joe Nocera / The New York Times

The technical term for the kind of derivatives that really got us into trouble is "bespoke derivatives". Bespoke means one of a kind. And these were complicated contracts that covered a particular, you know, one deal only. It couldn't be replicated. It wasn't like buying a share of IBM that is exactly the same as every other share of IBM. You bought a credit default swap; it would be built around a particular series of deals. It would have a particular set of terms. It would be one of a kind.

This is, by the way, why this stuff became so untradeable. How do you trade a one-of-a-kind? There is no real market for them. It has a utility as a contract on a one-on-one basis. But there is no trading function. And that has been part of the whole problem. They don't mark to market -- i.e., because there is nothing to compare it to. What's out there that you can compare this one thing to? So they mark to model. They come up with fancy, financial models every quarter. And they mark this thing to the model.

And for many years, the model said they were worth more, worth more, worth more so you mark them up. And then finally the model said: "Uh, you know what? Foreclosures are up. Subprime is down. We have got to start marking them down." You start to blow up. But even though they are blowing up, you are still stuck with them. There is nothing you can do with them. You can't trade them.

Now why would Wall Street want them mark to model? And why would Wall Street want these bespoke contracts? Well, one reason is you make more money with the bespoke contract, with a bespoke derivative. You are coming up with a one-of-a-kind. The other party can't exactly shop it around for a better price. It is almost like you had a monopoly on this thing.

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So you charge more. It's a higher-margin product. It is really pretty simple whereas when you trade a share of IBM, the broker makes pennies. And if these derivatives had been standardized and put on an exchange, they would have (A) been more transparent and (B) you would have had a real market and not this fake, mark-to-model market.

So one of the big problems with the rise of credit derivatives is that Wall Street was terribly resistant to the idea of standardizing contracts and allowing them to be traded on an exchange because it would hurt their profits.

So instead, they fought tooth-and-nail to keep them as over-the-counter products where nobody could see what the real price was, nobody could see what they could trade for. And nobody really understood how much of them were out there until we got to the financial crisis and it was hundreds of billions, it was trillions of dollars in notional value.

Analysis: What Ought To Be Done Now …

Gary GenslerChair, Commodity Futures Trading Commission (2009-Present)

The financial system … terribly failed the American public. And the financial regulatory system failed the American public. There are many parts of that failure. But one of the failures is that we have not been regulating the over-the-counter derivatives marketplace. …

The people in the CFTC are thinking nearly every day about the derivatives marketplace whether it's the derivatives marketplace we call futures or the derivatives marketplace we call "swaps" or over-the-counter derivatives. They're thinking about both.

And if I can just use a term -- the reason it's called "over the counter" is because it's not on an exchange. It's as if you walked into a store and you just personally bought something over the counter. In this case, you go to a large Wall Street firm and do a transaction, currently not regulated. It wasn't regulated in the 1990s and it's not regulated now. We should regulate them.

What should be and not be on the exchanges? I believe strongly that we need 2 complementary regimes. We need to regulate the dealers -- these

20-or-30 large global financial firms that issue these derivatives. How should we regulate them? We should make sure there's a lot lower risk and we do that by capital and having margin requirements. Capital means money put to the side in case of crisis and so forth.

We're going to enhance the integrity of markets by business conduct standards; protecting the public against fraud and manipulation; and lastly, promoting transparency by record keeping and reporting. …

But I don't think that's enough. I think we also need to mandate that the standard product -- the product that can be put onto an exchange and put onto what's called centralized clearing -- be done.

Why is that? An exchange -- just like the New York Stock Exchange or the Chicago Board of Trade for agricultural commodities -- brings transparency. That means anyone in the public could know what the price is, what somebody is willing to buy or sell this risk contract for. And even though they're very complicated contracts, if it's a small hospital in your township, if it's a small school or even a large

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business in your state, they could then look to this exchange and say, "This is where it's priced." They'd get the benefit of that.

Some people will argue … that these deals are being done between two very savvy organizations. These are not private citizens; you don't need the government overview. Your point of view on that?

… Every end user, every institution, even if they're big and savvy would benefit from knowing what some other institution just paid for just one of these things. We would promote economic activity, I believe, if we brought a lot of sunlight into this area. ...

Why is this important?

It's very important because we can't let this happen again. … You could be living in Iowa as a farmer or you could be living in Maryland as a doctor and have no relationship with a company called AIG. Then wake up one day and $180 billion of your money -- this is the American public's money; this isn't Wall Street's money -- had to go into an insurance company that was so lightly regulated that the system might have come down if they failed.

Brooksley BornChair, CFTC (1996-1999)

I think we have to close the regulatory gap. ... We need to take a lesson from the existing futures markets where exchange trading has been safe. As much as possible of the over-the-counter (OTC) derivatives market should be traded on a regulated derivatives exchange. The transaction should be cleared on a regulated clearinghouse. There should be robust federal regulation of any remaining OTC derivatives market. And personally, I think that remaining market should be limited as much as possible to no more than the customized contracts that are needed for specific businesses to hedge particular business risks. ...

If this moment passes again, the consequences are what from your perspective?

I think we will have continuing danger from these markets and that we will have repeats of the financial crisis. It may differ in details. But there will be significant financial downturns and disasters attributed to this regulatory gap over and over until we learn from experience. …

Do you think most people know there's no government regulation in this territory?

I don't know if they do or not. All other financial markets have some kind of government oversight protecting the public interest.

But not this?

Not this one. This one had very good lobbyists. The very same entities that are lobbying today to limit the effectiveness of a new regulatory reform are the people who in 2000 and 1999 deregulated these markets entirely. ...

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Michael GreenbergerDirector, CTFC Division of Trading and Markets (1997-1999)

It's ironic because Obama has essentiality brought back many of the actors who were unsympathetic to our point of view in 1998, 1999, 2000.

However, from my perspective -- and I believe from Brooksley's perspective as well -- the lessons have been learned. Recently, the Treasury proposed a white paper. It's confused and not as clear as one would like. But embedded within it is a program that comes in the direction of where Brooksley and I were 10, 11 years ago. ... My view -- and I believe Brooksley's view -- is right now that they have put forward proposals that are meaningful and strong. ...

The benefit now -- and the difference now -- for Obama and the Treasury is (A) the understanding of what just happened; (B) people like [CFTC Chair] Gary Gensler -- who was a Goldman Sachs partner and a protégé of Bob Rubin -- have come back into power and they have given every evidence of the fact that they have learned their lesson. They are advocating the kinds of things that we advocated 10-or-11 years ago.

Right now, all I can tell you is that the battle is evenly matched. You would think after everything we've been through there shouldn't be a battle; it should be understood. No, no, the financial services industry has organized itself and will pitch very, very hard for continuing to have these markets be unobserved by anybody outside of the banking system or their customers. No capital requirements, no fraud controls, no manipulation controls and no regulation of the intermediaries. It's going to be a close-fought battle.

Ron SuskindAuthor of The Price of Loyalty

We only have a few people here in Washington. I mean, look at the mismatch. For every thousand of them, we've got one person. Every 10,000, we have one person. They're big; they're well funded. They're moving at lightning speed. There's innovation and ingenuity. They're just exploding with the new thing every day. And sometimes they don't even know it inside of the big golden temple. How are we going to know it here in Washington?

And frankly, most of the people who go through this part of public service, they're in and they're out the other side because -- my God! -- the riches are vast. If you spend time in the SEC or the CFTC or one of those buildings in Washington, you are a person of value. You did your public service and God bless you. But now, you can make some real money because that's what this Country's about. Don't you forget it. And so it is a mismatch.

Blythe MastersCFO, JPMorgan; in 1997, she was part of a group at JPMorgan who created credit derivatives

he fact is the regulatory framework … is one that is very much defined by either products or corporate entity charters. So even though your activity may look the same irrespective of whether you're an insurance company, a banker, a broker/dealer, hedge fund, a private equity company, your regulatory framework, your restrictions, your legal powers are utterly different depending on what your corporate charter looked like. …

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As we ran into this financial crisis, you had mortgage originators that were non-banks that were operating with one set of rules. You had insurance companies operating with another set of rules. You had broker/dealers under SEC supervision under another set of rules. You had banks under another set of rules. You had hedge funds under no rules. You essentially had a mish-mash -- a patchwork quilt with some large holes in it -- of regulation and yet actors within the financial markets who often had very similar business models.

That is what needs to be tackled through regulatory reform. We need to reduce the number of different regulators that are accountable for addressing these issues. We need to empower a smaller number of regulators on a consistent basis to govern activities as a function of the risk they create, not as a function of what label they bear.

And if you can fix that, then there will no longer be the notion that there is a "black box". If you are actively engaged in the derivative market, if your activity is above a certain level or size or significance, then you must be subject to oversight by the following regulator and subject to the following capital requirements. That is the type of approach that we need to develop. …

… Could the over-the-counter derivative market actually operate if there was transparency, if there were exchanges, if everybody knew what everybody else was doing nowadays?

… Yes, absolutely. The over-the-counter derivative markets can exist with transparency. The biggest, most transparent market in the World is the market for U.S. government securities, is an over-the-counter market, just for the record. And there is no inherent conflict between having a degree of transparency and the ability of those markets to function.

One of the important features of over-the-counter derivatives is they are not standardized to the point that you have a one-size-fits-all approach. You need a one-size-fits-all approach to trade something on an exchange.

So the question is can you have non-exchange-traded activity that is still sufficiently transparent to address the regulatory and systemic risk issues? And the answer to that is yes. There are a number of tools for achieving that. One is the use of central clearing for those products which are sufficiently standardized to be amenable to that. And the other is regulatory reporting. You put in place a framework … that says your activity will be transparent to a regulator that is tasked with the management of systemic risk. Then you have the transparency that you need from a regulatory point of view to know whether there's someone out there that has accumulated an undue quantity of risk without the adequate capitalization. …

By and large, there's already a tremendous amount of price transparency in the over-the-counter derivative markets. It's not something that the man on the street would access. But it is something that institutional investors and market participants have plenty of visibility around. …

What's important is that we don't impose costs on activity that don't achieve societal benefits. So, insisting on real-time price transparency so that every transaction every second has to be transparent to the whole World? Well, certainly that might have inherent benefits of being transparent. But at what cost? At what cost to liquidity? At what cost to the providers that have to carry the burden of making that degree of transparency available? …

So the key here is that there needs to be intelligent regulation -- not brute-force regulation that essentially destroys the benefits of these products. And destroying over-the-counter derivatives or legislating them out of existence would hurt the World. It would hurt growth. It would hurt liquidity in

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all markets. It would hurt the ability of people to borrow, the man on the street and the corporation. That would be a bad thing.

So we need to not over-react. It's important that we react, don't get me wrong. The notion that things need to change is very clear. But it's got to change sensibly and it's got to be clear what we're trying to tackle.

Joseph StiglitzCouncil of Economic Advisers (1993-1997)

The challenge we have right now is are we going to create a financial system that actually does what a financial system is supposed to do? Provide credit to small and medium-sized enterprise? Manage risk? Help homeowners manage the risk of owning their home? Provide capital to new enterprises, money to the venture capital firms? -- these basic core functions of the financial markets.

Our financial markets failed. And they failed massively. Take even one simple idea: electronic payment mechanism. Modern technology allows for us to have an efficient electronic payment mechanism. It shouldn't be the case that when you go to a store and you want to pay with a debit card that that merchant has to pay 1 percent or more to the bank. It should cost a couple of pennies.

The financial market would like to go back to the World as it existed before 2007 because they did very well. But our financial markets were too big. They were garnering over a third of all corporate profits. What should be a means became an end in itself. And remarkably, it didn't even do what they were supposed to do.

So this is a dangerous moment because if we don't get it right, we are likely to wind up with an even more politically influential financial system, banks that are even bigger, more too big to fail, too big to be financially resolved, and so the risk of another crisis some years down the line is going to be greater. The risk that our economy's performance will be weaker. The risk that there will be greater inequalities and a sense of injustice in our society will be higher.

So I think this is really a moment. I was very hopeful that in the aftermath of the crisis we could see what had gone wrong and say, "Let's fix it." But it may be that we are passing that critical moment. ...

Harvey PittChair, Securities&Exchange Commission (2001-2003)

If government really wants to correct the deficiencies, a lot of the specifics that we're seeing now are not really as well directed toward getting the problems under control. They really are directed at answering last year's crisis.

And I think there are certain things that need to be done.

First, there has to be a universal requirement that anyone that takes money from the public that can have an impact on the economy must provide a continuous flow of significant data. The nature of the data will change over time because as things evolve, you get smarter and nobody is sufficiently prescient to figure out all the data we need today for the rest of time. It won't happen. But there ought to be power in the government to require people on a regular and continuous basis to provide significant data.

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Second thing you need is for government to be obligated to analyze that data and disseminate the data back out to the marketplace.

Some folks are concerned that, for example, their proprietary trading activities and other things may be compromised. But we've had a long history of being able to deal with those kinds of concerns. And they can be dealt with either by aggregating data or by having some delays in what gets published. But nonetheless getting the data out. The Government has to know what is going on. That's critical. In essence, that is a very easy cure. …

And ... there has to be a clear assignment of responsibility.

When the subprime crisis arose and I met with every government agency I could think of that had or should have had some interest in the matter, I found that the first question I was asked by virtually every agency was, do we even have any authority to deal with this?

What was the answer?

My answer was yes, there is authority -- particularly to deal with the types of things we saw evolving. But that takes a lot of effort to persuade the Government to act, particularly in the face of affirmative legislation saying you shouldn't regulate certain areas. So I think there has to be a grant of authority.

The third thing that I think is absolutely critical is what I call "residual regulation".

I think that government has to have the ability to set tripwires, to set so-called circuit breakers. And when those circuit breakers are tripped, the government then should have complete authority to stop the trend dead in its tracks before it becomes a problem and even before the problem becomes a crisis.

So even if you're not going to regulate specific areas in detail up front, that isn't the same as saying that government shouldn't have the ability to stop trends it believes are destructive and so on. …

With respect to how you then regulate, I guess what I would say is that I think that you need a truly independent body. I think the Federal Reserve is the appropriate body to do two things. But only two things. One is monetary policy. And the other is to regulate systemic risk.

The reason you need an independent regulator is because if the political side of government -- any Administration -- has control over what is deemed to be systemic risk, then you can have the wrong types of criteria directing whether government acts or doesn't act. And that, in part, is a major concern I have with the current proposal.

I think there's a lot of good in what the Administration is proposing. But trying to put all of this under the Treasury, in my view, is a mistake. An independent Fed -- and a truly independent Fed -- could do those two functions. And I think those two functions would consume an enormous amount of energy.

So I think that all of the bank regulatory functions should be alleviated. That is, the Fed should cede those along with all other financial regulatory powers from other agencies into one overarching agency or entity like a Financial Services Authority in London, or what have you, that would maintain the independence of various functions.

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For example, the SEC has very critical functions and those should continue to be independent. But I think by combining the regulatory apparatus, you can avoid what I like to refer to as "regulatory arbitrage" where people try to figure out who will be the lightest regulator, the easiest regulator, what have you.

What you really want is a regulatory system in which everyone performing the same types of functions or dealing in the same types of instruments (whatever they're called) is subject to the same types of restraints and restrictions. That would be the way that I would try to deal with the current crisis.

Henry KaufmanDirector, Lehman Brothers (1995-2008); author of The Road to Financial Reformation

From my viewpoint, what ought to be done is supervision ... should be centralized -- as I indicated in my book -- with the Fed. But after we have taken another look at the Fed and re-examined its strengths and weaknesses.

The head of supervision of our financial system should be a vice chairman of the Federal Reserve. He should have under him the responsibility of a substantial staff that supervises closely the 15-to-20 largest financial institutions in the United States. He should be required in conjunction with the President of the United States to render a report annually on the strength and well-being of the largest financial institutions in the United States, that they should certify.

That would bring a far greater discipline into the process. It would give the Chairman of the Federal Reserve Board and this chairman of this new supervisory authority a much greater responsibility from which they cannot withdraw if something goes wrong.

And we've got to fight hard to have a more centralized supervision over major institutions outside the United States in the industrial world. By major institutions, we're not talking about hundreds and hundreds and thousands of institutions. All it requires in the United States is 15-to-20 financial institutions, which are conglomerates.

Now, the dilemma in dealing with those is the big fight.

If you keep them as they are, they have to be too good to fail. And if they're going to be too good to fail, they're going to have to be constrained on their capital requirements. In other words, capital requirements would have to be raised significantly and their profits have to be constrained. That is an extraordinary change from where we are today.

They will become -- and should become -- financial public utilities; that they have a responsibility far beyond anything that they've had heretofore. The fact is the financial institution is different than an industrial company. It deals with our savings, with our temporary funds. These institutions have major roles to play in the well-being of our financial system and in the American economy and the global economy.

But is there any likelihood that the 15 major institutions like that in America are going to yield? Has the problem been bad enough? Have they been scared enough? Have they been warned enough?

Well, they're not in a good position. Many of them are indebted to the U.S. Government. Quite a few of them have shares that are owned by the U.S. Government today. And therefore, their bargaining

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position, so to speak, has been diminished. But it's still very powerful in the public arena in terms of trying to influence political people in Washington, undoubtedly. That's where the battle will be fought.

Joe Nocera /The New York Times

I don't think the impulse to regulate has completely abated, even though the dust has settled a little bit on the crisis. What I do think is that banks have recovered enough to feel that they can push back. I mean, it's pretty incredible that they are pushing back against the new consumer protection agency. …

The other thing is that the regulations that have been proposed and that may soon be law, they kind of accept certain things that don't seem particularly acceptable -- i.e., there is such a thing as too big to fail. Or that there should be only limited clampdown on derivatives; that derivatives are still going to be a huge part of the financial world.

To me, it feels as if they are trying to change things on the margin rather than trying to make wholesale, substantive changes in the way the system works the way Franklin Roosevelt did during the Depression where he created the SEC and they passed the Glass-Steagall Act and they separated banks from investment banks. There is nothing remotely in the Obama administration's regulations that would suggest anything as bold as that.

Why?

It's hard to know why. I think part of the reason is they are moving too fast. As much as we need re-regulation or better regulation, nobody in Government has really taken the time to really examine what went wrong and what needs to be done. They are moving on the fly. They are trying to get this behind them. The Administration has other priorities. President Obama didn't come to office with a lifelong ambition to solve a financial crisis. He came to office to solve health care. So the sooner they can get this behind them, the happier they will be.

Sheila BairChair, Federal Deposit Insurance Corporation (2006-Present)

I think both the Treasury and the Fed are very much committed to regulatory reform. There may be different views about how to achieve that. But I think the regulatory community at least does want reform; will push aggressively for reform; and hopefully we'll all try to provide the technical expertise and drafting help and arguments pro and con to assist Congress in making the decisions that they will need to make.

… What's at stake and what's the worry?

We're not out of the woods. And I think in some ways, the situation has become worse because government did have to come in and stand behind a lot of very large institutions. The implicit too-big-to-fail doctrine has now become explicit. And so longer term, if we don't have a good exit strategy and a more robust regulatory regime coming out of this, we're going to have the same incentives for high risk-taking that we had before, perhaps even worse now because investors and creditors will figure: "Well, maybe I can make a lot of money if I can encourage high-risk behavior, high-return behavior on the part of these institutions. If it doesn't work out, well I'm just limited to my investment and the Government is probably not going to let them fail anyway. So let's bring the punch bowl back to the party." …

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We need to end "too big to fail". We need stronger regulation of these very large institutions. We need to give them incentives to downsize. Those are certainly at the top of my priority list -- I think at the top of the Administration's priority list, everybody in the regulatory community. And I hope Congress will maintain the will to get that done.

… What are the obstacles? …

The complexity of these issues and the complexity of the legislative solutions weighs against them. There are lots of different things that need to be fixed. There's no one silver bullet here.

Though we can agree on broad objectives. We need a resolution authority, first of all. If an institution gets into trouble, it needs to be allowed to fail and there needs to be an orderly mechanism to let that happen.

We need better regulation and stronger regulation of any systemic institution, regardless of whether a firm voluntarily comes in and wants to become a bank holding company or not. We need stronger consumer protections across the board.

There's broad agreement on those priorities. There are different ways to achieve those. And I think people of good will can work together to a common solution.

But there is a lot of industry resistance still to a lot of these proposals. But I am heartened. We are very actively engaged in both the House and Senate. And I think that frankly, the Hill is not really listening to them. I think Congress understands that this is a very dire situation. There was not enough regulation and that it needs to be fixed. And it's really core to the future of our economic health and the preservation of our capitalist system to fix this and make it right.

So I'm actually optimistic. I think Congress does want to do the right thing.

Roger LowensteinAuthor of When Genius Failed

The whole regulatory system wasn't bad. But there were some holes in it and you want to patch them. You don't want to unnecessarily restrain speculation although there's some areas -- you know, do we need a credit default swap market? Do we need a market where people can gamble on whether-or-not companies are going to go bankrupt? Most people still say yes. I would say no.

But not every new drug is approved. We have an agency that looks and says "This one, on balance, looks like it could do more harm than good." So we might think about that financially. Not every financial innovation does more good than harm.

Where would those decisions reside? At a sort of super-powered Federal Reserve?

One proposal … is to limit derivatives to exchange-traded contracts. And then if someone exchanged, the exchange and its regulator has to approve that. So if someone comes out and says "I want a new contract where we can gamble on companies going bankrupt," some worry that well, maybe that's not such a great idea. You laugh, but that's what we have. It's called the "credit default swap market". Maybe that's not a great idea.

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Economist Bob Shiller wants a housing futures market. So is it necessarily a good idea to allow people to speculate on the price of center-hall Colonials in Indianapolis so that, you know, oil traders lose money and they got to get out of something, suddenly housing markets crash.

Actual liquidity in trading is not always a good thing. It's a very hard thing for people to grasp. But we had enough capital raised in this country, enough stock sold, enough capital raised before we ever had stock index futures, before people could trade a million shares in 500 different companies in a second. In those days, people had to take it and make an individual decision about it: "Do I want the stock? Do I not want the stock?"

And now we have this great innovation so that people can sell zillions of shares without thinking about any them. Well, does that sound smart to you? It doesn't to me.

Analysis: What if they had listened to Born on Regulating Derivatives?

Harvey PittChair, Securities&Exchange Commission (2001-2003)

My sense is that given the lack of government expertise in these markets, the likelihood is that even had there been regulation, it would not have been able to prevent the kinds of catastrophic events we've now seen.

Because?

Because there's a lack of real understanding on the part of the people who have to create the regulations, for one thing.

You mean it's just too sophisticated?

It's not that people in the Government aren't sophisticated or can't deal with sophisticated problems. It is that Government is always a light-year or two behind the marketplace. It's the marketplace that creates, that has ingenuity, and so on. Government spends a lot of time catching up.

Part of the difficulty -- and we see that even today -- is that Government's response when things go wrong is usually to try to fix the last crisis instead of preventing the next crisis. And the situation with OTC [over-the-counter] derivatives is sort of a cautionary tale about the way regulation ought to be evolving and adopted, as opposed to the way it looks like it will actually evolve and be adopted. …

Joe Nocera /The New York Times

There is no way of knowing. It is a giant hypothetical. … It is certainly possible that the crisis could have been avoided if Brooksley Born had been able to regulate derivatives. It is possible. It is also possible that 10 years later the CFTC [Commodity Futures Trading Commission] would have proven as inept as the SEC was in finding Bernie Madoff, you know?

So she had a powerfully good impulse. She was right on the merits. It might have made a difference. But we will never, ever know. …

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Joseph StiglitzCouncil of Economic Advisers (1993-1997)

I think to understand the crisis of 2007, 2008, 2009, you have to understand that it had many, many sources, many, many factors that contributed to it. The underlying recklessness of the banks, their perverse incentive structures, the fact that they were too big to fail encouraged them to engage in excessive risk taking meant that if you had tied their hand in one direction, it's likely that they would have moved in another direction.

But it's absolutely clear to me that if we had restricted the derivatives, some of the major problems would have been avoided. Some of what it has cost American taxpayers -- a great deal would have been avoided.

I think there is a very high probability, for instance, that we would not have had to pay out the hundreds of billions of dollars that have gone to AIG, that much of the other financial turmoil we would have avoided.

But we still would have had the problems of the mortgages. We still would have had the problems at rating agencies.

So I think it's too simplistic to say that if we had done this one thing, we would have avoided the crisis. ... I view her experience as a dramatic illustration of what was wrong with the system and the power of the financial markets to resist doing what should have been done. But they did it with predatory lending; they did it with mortgages; they did it in area after area. And it would have needed a comprehensive attack to stop that.

Mark BrickellChair, International Swaps and Derivatives Association (1988-1992)

If the "concept release" and the review of policy that was precipitated by the release had reached a different conclusion, the results would have been problematic for the financial system. Because if the conclusion was that these contracts should be regulated by the Commodity Futures Trading Commission, they would have to be futures contracts in order to fall within the scope of the CFTC's authority. And if they were futures, then some portion of $80 trillion in notional principal amount would have been entered into illegally and the contracts would have been unenforceable.

So it was potentially a cataclysmic event for the banking system and for corporate America relying on the hedges that had been provided by the banks. If all those contracts had been torn up, it would have caused many losses. It would have been hard to determine where those losses would fall. But certainly it would have been of great difficulty to the banking system, and therefore to the financial system as a whole.

David WesselThe Wall Street Journal and author of In Fed We Trust

It's easy to look back on the things that we didn't do and the problems that were caused. No one ever gets credit for the things that get fixed and then didn't blow up.

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One thing that did come during the 2000s -- partly as a result of some of the stuff that happened at LTCM -- was the Federal Reserve Bank of New York was horrified to discover that a lot of this trading in derivatives and credit default swaps was being done in a very old-fashioned, sloppy manner. The paperwork was a mess and there would be days between the day that you sold something and that the other guy who bought it acknowledged that he had bought it.

They were worried that if you had a problem and the merry-go-round stopped, there would be a lot of disputes about who had done what to whom. And so they actually did clean that up.

We had huge problems. We made enormous mistakes. But it could have been even worse, hard as that is to believe, if there had been this paperwork problem.

And the one thing -- maybe the only thing -- that the Federal Reserve Bank of New York under Tim Geithner actually did that we saw had some effect was to get all these guys to say: "Okay, you've got to have a modern financial back office here. We can't have the situation where huge percentages of your trades are unconfirmed and stuff."

So it's not like nothing happens after LTCM. It's not like nothing happens after Enron. It's just we didn't seem to fix the fundamentals. We fixed some of the minor problems.

… It's this black box -- trades are happening and people don't know. At LTCM, what happened was banks that thought they were the only lender discovered there were 13 other guys in line, right?

Right.

And said: "Oh my God! If only I would have known, I would have given less. The leverage wouldn't have been as bad." The argument was that if you could get at least an exchange going, you might know.

Right. Another piece of evidence in support of the case that Brooksley Born identified something that was, in fact, a problem is to look at what Chair of the National Economic Council Larry Summers and Treasury Secretary Tim Geithner are proposing today as a result of the Great Panic of 2007 and 2008.

They are proposing that more derivatives be traded on exchanges. And that if you play in this game, you have to have what they call margin. You have to put something up so you can't just bet without having anything on the table.

And so in some respect, those are things that a rational conversation of the Brooksley Born concept paper might have produced.

But the circumstances have changed a lot. The market's a lot bigger and the dangers are not theoretical.

She was talking about something that she suspected was a problem but wasn't yet a problem. Now we see there were things that she identified that did become problems and we're trying to fix them. It is, of course, human nature that it's hard to fix a lot of problems before they're problems. And she will become a case study in that.

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Sheila BairChair, Federal Deposit Insurance Corporation (2006-Present)

What if Brooksley Born had been listened to? …

You never know for sure. I think there could have been a significant difference. A lot of this, it doesn't take a terrible lot. For instance, transparency. The credit default swap [CDS] market -- even a regulator cannot know. If I want to know who holds all the CDS positions on Bank X -- so they're betting that Bank X may go down -- as chairman of the FDIC, it'd be kind of helpful information to know who out there has got an interest in a particular bank going down.

I can't get that information right now. We're working on it. The regulators are working together to try to get all that information in the same place and allow us to access it. But the fact that no regulator can get it right now -- and the people who are taking those positions know that -- there's really no chilling effect that we might otherwise have if they know that the SEC or the FDIC or the Fed or whoever knows what kind of positions they're taking; how big their positions are; how frequently they're changing them, can match them up against whether they're maybe short the stock.

Just having that kind of information and transparency can have a very good dampening effect on high-risk, speculative or potentially manipulative behavior. So that is do-able, you know?

And I think probably if we had done just common-sense steps like that in the late-90s or even earlier, we could have curbed a lot of this excessive risk taking. But we didn't. They were very opaque markets and still are. But we're working on it.

Roger LowensteinAuthor of When Genius Failed

This meltdown had many fathers. Y ou can't pin this all on Brooksley Born's opponents. You can't pin it all on the Federal Reserve. You can't pin it all on the credit rating agencies. You can't pin it all on dumb, greedy bankers. You can't pin it all on dumb or dishonest mortgagees, homeowners lying on their applications. All those parties played a hand.

All you can say is had restraint been exercised, as she urged, there would have been a little less. Had the credit-rating agencies done a little better job, it would have been a little less. And so on down the line.

But you've got 15 million people out of work -- you can't pin it all on one meeting with Brooksley Born.

Can you pin it all on this idea of deregulation being next to godliness?

Yeah, I think it's less a matter of Brooksley Born exclusively, or exclusively the lack of regulation of mortgages, or of allowing investment banks to combine with commercial banks -- it's this religion that swept through markets and swept through Washington that whatever bankers wanted to do was a good thing with no questions asked.

If we could have braked that religion, I think we would have had a much less serious situation.

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Timothy O'Brien /The New York Times

I don't think people can dismiss good management and good regulation. Would Citigroup have been a different bank if it had different management? Certainly. Would it have not blown up if it had other people managing it? Certainly.

Does the regulatory system depend on quality people making the right decisions and trying to enforce what is on the books and making sure you put stuff on the books that needs to be there? Does that make a difference? Absolutely.

Had Brooksley Born been enfranchised, had Brooksley Born been listened to, had Brooksley Born been made part of the process, would that have had a different ending for what subsequently happened in the derivatives market? Certainly.

Certainly?

Sure. If people actually empowered her to do some of the things in the derivatives market that she wanted to do -- which by the way, are some of the things they're advocating right now at the White House -- put these things on an exchange of some fashion and make sure there's greater transparency around them. There's a big debate right now as to whether-or-not the White House is actually going far enough in that regard.

But certainly there would have been a different world financially if people in the late-90s had taken Brooksley Born more seriously and had looked at potential problems in derivatives and had responded in a regulatory fashion that made since. Sure, the World would have been very different.

Ron SuskindAuthor of The Price of Loyalty

History is a complex dance and it's hard to map causations. It's hard to say if this had happened, then that would have been the result or a thing wouldn't have happened.

I think that the key thing that is really at stake here is something that seems part of the horse&buggy department in this era of message, this era of power having its way in so many parts of American life. It is this idea of trusting truth. People don't. Certainly in the public space.

Let's ask ourselves hard questions. Why is it we think this thing? Is there anything here that's hard data, facts? What is it we've learned? Even if it means that somehow it won't be as easy going forward, we'll have to think again and come up with new innovations, new thoughts, new clarity and understanding.

And this is another example where Brooksley steps up and says something that does scare the bejesus out of everybody. But at that point, no one really stops and says: "Wait a second. What exactly is she saying? This is not about what I'm getting paid this year. This is not about what I said a few years ago that I'll be challenged with now if I contradict it. This is really about trusting truth." …

I think the lesson going forward is that when moments like this occur -- even though there's a great desire to attack the skunk at that garden party, to get rid of it, to say: "You got a party going on here? What are you talking about? Who gave you an invitation to this party?" -- instead we say "Well, if

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somebody has the temerity to step up and say 'I have a position that is supported by real facts; let me please show them to you,' that people will stop and think and listen."

And I think this is a case where we didn't do that.

Daniel WaldmanGeneral Counsel, CFTC (1996-1999)

My feeling was that it really was a product of the times. There are way bigger forces involved. If you lived through the 1990s and the early part of this decade, you just saw very strong faith in our financial institutions and in markets and very little interest -- both by policy-makers and folks within the government -- to have active government involvement.

So I never felt like well, if they just listened to us that the World would have changed. There were very BIG forces at work that made what happened in some way inevitable.

You mean, even if you would have prevailed and in some way they would have had to have some transparency, it wouldn't have been enough?

I think that's right. I think you need to go through periods like this for people to really understand the risks. And again, I come back to my bank regulators. You have institutions that were enormously leveraged and taking very, very highly speculative positions -- yet under the nose of scores of regulators. It was (A) I think a function of the complexity of a lot of the things that were happening but (B) a function of the sort of attitude towards regulatees -- that they know that they're in control, they know best, and that we're going to step back and let them do their thing.

Analysis: The Forewaring in 1998: Long-Term Capital Management

Roger LowensteinAuthor of When Genius Failed

People had always wondered sort of academically would it be possible to have a derivative chain reaction. Some collapse that would lead to a so-called systemic crisis meaning obviously that the system was threatened, not just one firm or two firms?

That summer of 1998, out of nowhere Russia -- which had been the darling of Wall Street, everybody wanted to float bonds for Russia -- Russia defaults on their ruble-denominated debt.

And ... basically markets say: "Okay, it was a bad move to take risks on Russia. We don't know what other risks are good. Therefore, we don't want any risks."

Long-Term Capital Management (LTCM) is a hedge fund in Greenwich, Conn. which really no one had heard of except for the Wall Street cognoscenti. It had fewer than 200 employees, had 16 partners, but was leveraged something like 30:1 or 40:1. Had all kinds of derivative bets. But all their bets were pointed one way. Which was it was betting people would become less worried about risk.

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And when they became more worried about risk -- and the firm had all sorts of models that said, no matter what happened, based on history, they couldn't lose more than $35 million a day -- they started dropping $300, 400, 500 million every day.

They had had $7 billion of capital. They thought they had so much capital, they gave back $3 billion to their investors right before this. Then they start losing these chunks.

Everyone else on Wall Street had similar bets to them. They're sort of sucked down into this vortex, and the more they try to sell out of these things, the more the steamroller goes.

And Wall Street freaks is what happens.

The New York Federal Reserve calls in the top 14, 15 banks to say: "LTCM's going to go down. Who knows who it'll take down with them? You guys ought to do something with them." And 14 banks agree to put up a few hundred million each, about $3.5 billion total. But one bank refuses. That was Bear Stearns, incidentally. …

One of the things with LTCM is that no one had any idea. … No one knew how many other people had the same position and how much the market was on one side of it, how big that side was. And this was one of the things that making derivatives exchange-traded might go to.

So there was this momentary period when people said "You know, we got pretty close to the edge." LTCM was a very scary moment.

It really was?

Yeah, it was very scary. Credit markets around the World just shut down. There was a 2-, 3-, 4-week period of real panic. People were very, very frightened. Even Goldman Sachs lost a billion dollars. They had to cancel their public offering. Merrill Lynch lost a tremendous -- and these firms were worried about, in some cases, their future; in some cases, their survival.

It was a real bloodletting. So there was this shrinking back then. And people said a lot of things which they ended up not meaning, like "We're never going to get leveraged again like this." Of course, they did. And "We're going to look harder at derivatives." That was another one of the things they said that didn't last long.

Who worked at LTCM?

Long-Term had two Nobel Prize-winners, economists Bob Merton and Myron Scholes. Scholes, in particular, was a real free-market advocate. He used to say that only a fool paid his taxes. He didn't mean that people should be dishonest or illegal or commit crimes. He meant that anybody with a brain, half a brain, could figure out an honest way to get around them. And he was a specialist employed for that.

The firm also had the former vice-chairman of the Fed (Alan Greenspan's number two) on it. It had a credo, too, LTCM. And the credo was really Alan Greenspan's credo. The credo was "Markets get it right." … Because they get it right, people aren't going to be as worried about there being panics. And over time, prices will get more right and more right which, to them, meant less and less worry. And therefore, we can bet against risk. That is to say, bet against people being worried about risk.

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So in some sense they were the personification or the embodiment of Alan Greenspan's credo in a financial firm.

What did they get wrong?

They got a couple things wrong. The famous saying attributed to Lord John Maynard Keynes -- I don't know if it's true or not -- but that markets can stay irrational longer than you can stay liquid. If you're not leveraged at all, if you just go out and, say, buy a stock or buy a bond and it goes down, you come back tomorrow. If it goes down the next day, you come back the day after that. And you just hang in there.

But if you're operating on somebody else's nickel, you don't have a tomorrow. If you're leveraged 10:1 and your asset goes down by 10 percent, you're wiped out. …

So one thing they got very, very wrong was thinking that not only would their bets be right but also they would always be recognized as right. It'd be never, ever a day when markets would say "Hey, we're a little worried."

And they were fundamentally wrong in another sense which is that markets were not as safe. There was this whole belief that recessions were done, the economic cycle was over, the Cold War was over. It was just going to sort of be happy sailing. I mean, it sounds ridiculous now, but it wasn't ridiculous. It was a very seductive point of view after 6-or-7 years of a gradually increasing, accelerating economy, mostly Peace on Earth pre-9/11.

In their view, which they embodied in their trades, things are going to get better and better and better and better. We're done with history. It was political scientist Francis Fukuyama's thesis if you could have canned that and put it into a financial trading engine.

And it turns out we weren't done with history. …

How did systemic risk emerge? What was at the heart of it?

A couple reasons. All of the major banks financed Long-Term. So as they saw Long-Term's ghost, they were looking at themselves or the effect of themselves.

And they held a lot of the same assets. We call Long-Term a "hedge fund" and made a big deal out of it. It was a hedge fund. But all the investment banks and all the commercial banks had hedge fund-like operations. And they were all playing the same trade.

So as Long-Term was losing money, they were all losing money. And it was one of these vortex-like situations. So what happens? Long-Term, they start to try and sell to get out of i, and that drives down the value of their holdings more. And then the next guy says "Well, if Long-Term's going to sell, I'm going to try and sell ahead of them." And possibly some people who weren't even in the investment started selling just to make money and enhance the misery of those who were in it.

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Brooksley BornChair, Commodity Futures Trading Commission (1996-1999)

I got a call from the Treasury Department probably the weekend that it nearly collapsed. This was in actually September '98. And I was told that the very large hedge fund was almost collapsing, that it had $1.25 trillion in notional value of over-the-counter (OTC) derivatives and it only had $4 billion in capital to support that enormous investment and that the markets had turned against it ... so that it was going to default in a very major way, leaving the counterparties in the derivatives contracts -- who happened to be the big OTC derivatives dealers -- in the lurch in a major way. And I was told that the Federal Reserve Bank of New York was trying to facilitate an arrangement whereby the large over-the-counter derivatives dealers took over LTCM by buying it out.

What did you think when you heard that?

I thought that it was exactly what I had been worried about. None of us, none of the regulators had known until Long-Term Capital Management phoned the Federal Reserve Bank of New York to say they were on the verge of collapse.

Why? Because we didn't have any information about the market. They had enormous leverage. 4 billion dollars supporting $1.25 trillion in derivatives? Excessive leverage was clearly a big problem in the market. Speculation? I mean this was speculation, gambling on prices, on interest rates and foreign exchange rates of a colossal nature. Prudential controls? I mean all these big banks had in essence ... extended unlimited loans to LTCM and they hadn't done their homework. They didn't even know the extent of LTCM's exposures in the market or the fact that the other OTC derivatives dealers had been lending to them as well.

They thought they were the only bank and there were 13 others on the list, right?

Well, at least there was a suggestion of that. There was some reporting of great surprise.

The other thing it showed me -- which I hadn't really been aware of before -- was the risk from tremendous contagion. Not only did these instruments, which supposedly are useful for managing risk, it multiplied risk and spread it around throughout the economy, but because of counterparty risk, one institution's failure could potentially bring down or adversely affect a large number of our biggest financial institutions.

The Federal Reserve opinion was that had the OTC derivatives dealers not stepped in and taken responsibility, this could have had a widespread, adverse, systemic impact on the financial system.

Meltdown?

Yes. A mini-2008, in effect.

One decade before?

Exactly. ...

So much for the argument that the market will somehow take care of itself and we don't need regulation, I guess?

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It disproved it to me. I had never believed that. I think anybody who has been a lawyer practicing in areas involving business regulation realizes that the public interest is not fully protected by the marketplace and the participants in the marketplace.

So LTCM happens and for a brief period, there is this eagerness to regulate. ... But it very quickly evaporates. Why?

Because everything was all right. Because all the big banks did step in and solve the problem by taking over LTCM and incurring losses themselves. But they protected the fabric of the Economy. And Congress was told by the over-the-counter derivatives dealers, by some of the other regulators that this was an anomaly -- this was not indicative of dangers in the market.

And I think any consideration of regulation probably came and went within a few days. …

Gary Gensler Chair, CFTC (2009-Present); assistant Treasury secretary (1997-1999)

At the time, the lessons actually came together in a report of the President's Working Group that following Spring. We felt that as a group -- and I helped to staff that report because it's a report of the secretary of the Treasury and the head of the Federal Reserve -- some of the lessons included that we needed to do more to regulate these markets and that the private-sector firms also needed to do more around risk management, their risk with these entities.

I believe the report that following Fall was the first time we recommended greater oversight of derivative dealers which were affiliated with the Wall Street investment banks. It led to some of our recommendations later to have what's called "centralized clearing" of these derivatives.

But looking back 11 years later, I think there's additional lessons about some of the moral hazard what happens when government gets involved, even in a private-sector solution in the financial markets. ...

Did we miss something? Were there things that should have been learned from Long-Term Capital that were not learned?

I believe that looking back now, all of us -- with the lessons we have from the 11 years passed -- should have done more to protect the American public. Long-Term Capital Management was ... smaller ... than these large institutions, the AIGs and the Lehman Brothers and the Bear Stearns that brought the financial system to the precipice last Fall. But I do think that there are lessons from that period of time about what we have to do going forward now. We have to lower the risk in the system.

One of the big lessons from Long-Term Capital Management is also that we have to make the system less interconnected. We live in a system that's highly-connected -- a global system. We all can go on the Internet and communicate with somebody in Malaysia or in France or buy products. But also the financial system is similarly connected. If one big institution is going to fail, tumble, it's so connected it might bring down the other institutions and bring down the American public. And I think that the great lesson we started to see in Long-Term Capital Management, it was rather interconnected even for a hedge fund.

I believe that's why we have to regulate derivatives now. We have to have these things called "clearinghouses" that help lower risk. They make the system less connected, these big financial

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institutions. We need to be able to let the system be less connected and thus if one institution were to fail, less prone to hurt the American public.

Blythe Masters CFO, JPMorgan; in 1997, she was part of a group at JPMorgan who created credit derivatives

I think that Long-Term Capital was … an enormous lesson in the dangers associated with allowing thinly capitalized -- in this case hedge funds -- to become major actors in the over-the-counter derivative space on an uncollateralized or unsecured basis.

The market practices around the management of credit risk associated with hedge funds changed radically as a result of that experience. And indeed, one of the things that has been quite notable during the course of all of this chaos is how very limited the impact of failure on the part of hedge funds has been to the system at large. And that is a notable positive that came out of that learning in 1998. …

The regrettable thing is that some of the inter-linkages between other financial intermediaries -- and the broker/dealers in particular -- really weren't raised by that event and didn't have any additional light shed on them as a consequence. And so I don't think that the facts around the Long-Term Capital incident really had much bearing on what subsequently happened 10 years later.

Henry KaufmanDirector, Lehman Brothers (1995-2008); author of The Road to Financial Reformation

The Long-Term Capital Management event was relatively quickly forgotten for a variety of reasons. Very few suffered from the event. There was no one that really had major losses, as such.

But the problem with Long-Term Capital Management continued on in bigger form later on. The use of derivatives accelerated afterwards and Long-Term Capital Management was a big user of derivatives. They had over a trillion dollars of derivatives that they had access to.

Number Two -- those who did the financing for Long-Term Capital Management, the various financial institutions, didn't really know the total involvement of the institution to which they were extending credit. Didn't know the total involvement.

But it was happening in a "black box"?

Well, they didn't know. But as a lender, you certainly should know with whom you're doing business and what they're doing. That carried on into much bigger size later on.

Plus, the techniques that were used by Long-Term Capital Management, the quantitative risk-analysis techniques that were used in judging one credit versus another, and working the spread between them, that quantitative risk-analysis technique accelerated rather than slowed down in the period afterwards or the period leading up to the recent crisis.

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David WesselThe Wall Street Journal and author of In Fed We Trust

I don't think that LTCM stands for derivates are too dangerous to use. It wasn't any specific instrument that's their thing. It's the notion that you could have lots-and-lots of leverage. You could borrow lots of money and make bets on things that you're very confident you understand and discover that you don't understand as much as you thought.

And in a sense, whether it's derivatives or securitized mortgages or all these other financial instruments, each one has its own peculiar characteristics and risks. But all of them have this common thread: People who think they're really smart -- think they can place a really big bet -- borrow lots-and-lots of money to enhance their bet and then discover they weren't as smart as they thought they were.

And there is an impulse right afterwards for some regulation to tighten things up a little bit. But that wanes fairly quickly. Nobody lost any money and, as you say, the taxpayer didn't get involved.

That's right. Even after Enron, with all its financial magic and everything there's very little that actually gets done on regulation. I think that one of the lessons that they're trying to learn now is that if you have a financial crisis and you discover there are vulnerabilities in the system, it's logical to say we ought not to rush to regulate and do all that stuff. But the other side of it is if you don't rush, you don't do anything.

And so nothing much happened. Reports were written after LTCM about risk management and the firms. … There were lots of thoughtful pieces written about what the lenders ought to do because that was one of the diagnoses, that it wasn't so much that LTCM did bad things. It was that LTCM did do bad things and everybody seemed to want to lend them money to do more of this stuff.

And so it led people to look at what should the lenders be told to do -- and the lenders are regulated in many cases -- so they don't get into this again. But a lot of these suggestions just fall on deaf ears and remain in the reports that stay on the shelves. Some get fixed.

It's easy to look back on the things that we didn't do and the problems that were caused. No one ever gets credit for the things that get fixed and then didn't blow up.

One thing that did come during the 2000s -- partly as a result of some of the stuff that happened at LTCM -- was the Federal Reserve Bank of New York was horrified to discover that a lot of this trading in derivatives and credit default swaps was being done in a very old-fashioned and sloppy manner, and that the paperwork was a mess. And that there would be days between the day that you sold something and that the other guy who bought it acknowledged that he had bought it.

They were worried that if you had a problem and the merry-go-round stopped, there would be a lot of disputes about who had done what to whom. And so they actually did clean that up.

We had huge problems. We made enormous mistakes. But it could have been even worse -- hard as that is to believe -- if there had been this paperwork problem.

And the one thing -- maybe the only thing -- that the Federal Reserve Bank of New York under Tim Geithner actually did that we saw had some effect was to get all these guys to say: "OK, you've got to

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have a modern financial back office here. We can't have the situation where huge percentages of your trades are unconfirmed and stuff."

So it's not like nothing happens after LTCM, it's not like nothing happens after Enron. It's just we didn't seem to fix the fundamentals. We fixed some of the minor problems. …

Was one of the lessons of LTCM this systemic risk problem? …

Yes. One of the lessons of LTCM is that an individual firm if it's big enough -- and more importantly, if it's interconnected enough -- can threaten the whole system. So in that sense, LTCM was a warning that we didn't understand or didn't take heed of.

LTCM was one hedge fund with not a lot of people, with a lot of borrowing whose failure threatened the entire financial system.

Systemic risk.

Systemic risk. That's the definition of systemic risk. People talk a lot about "too big to fail." Well, what does that mean? It means that if you go down, you're going to take us all with you. And the judgment at the time was if LTCM had an uncontrolled implosion, it would take us all with them. And so they worked out this rescue that didn't involve a lot of taxpayer money and didn't do a lot of damage outside of the narrow fraternity. So it didn't affect the way we looked at finance in the rest of the World as much as we wish it had, now that we know.

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