- I'm here today with
Professor Michael Greenberger,
Professor of Law at University
of Maryland Law School.
And we're here to talk about his new paper
on derivative's regulation
and how Dodd-Frank legislation
can be nullified by a footnote.
Michael, thanks for joining us.
- Very glad to be here, Rob.
- I remember years ago, you
and I worked on a project
called Make Markets Be Markets.
- [Michael] Yes.
- And I remember a very
striking presentation
done by Frank Partnoy who spoke
and presented a PowerPoint
where he showed the
earnings profile over time
of a financial institution, unnamed.
And then his second slide was
to just show the same thing
but with the name, Citigroup.
And at that time, of course,
Citigroup was in dire need of a bail out.
- Yes.
- His point was the balance sheets
and the earning statements,
the standard reporting are wearing a mask
and what they were masking
was special purpose vehicles
that were off balance sheet
which flowed back into the
holding company's balance sheet
where the bail out was required.
The point of all that,
in Frank's presentation,
was the public, particularly
in the aftermath of Enron,
where their fraudulent techniques
were not repaired by law,
became the practice of the
large financial institutions
and in essence, we found
out we were on the hook
as taxpayers for something far larger
than that earnings profile would suggest.
So I return now to the present
and I see your new paper.
And in that new paper, the
idea that the scope and scale
of outstanding derivatives
around the world
that originate with US banks,
we can't know.
And so that contingent
taxpayer's liability, again,
is, how would I say it, I'm not saying
we're on a cusp of a crisis,
but I'm saying in the event of a crisis,
we don't know what we're in for.
- That's absolutely right.
I mean, it should be said that
there is a certain euphoria
over the state of the
economy as we sit here,
unemployment is at a almost 20 year low
and there are other indicia.
But there's a lot of commentary
by very sophisticated
academics, market observers,
columnists that we are running up debt,
consumer debt, credit
card debt, auto loan debt,
student debt, at an amazing pace.
Defaults are occurring in those markets.
And that's what we saw
in 2008 with mortgages.
But the important thing is not
just that there are defaults,
but all of that indebtedness
has built around it
the same financial architecture
that surrounded mortgages in 2008.
Asset-backed securities,
collateralized debt obligations,
credit default swaps, and
naked credit default swaps.
When I get to naked credit
default swaps, what do I mean?
There are people designing
financial instruments
that allow you to bet, for example,
students won't pay off their loans.
Even though you didn't extend
the debt, you get rewarded
at the full cost of the loan
through a naked credit default swap.
That unmistakably, the use
of naked credit default swaps
is now legendarily part
of the American culture
because of the Big Short, the
book, Big Short the movie,
which is all about how
people figured out to bet
that mortgages wouldn't
be paid and made billions.
That same architecture that
was present in 2007, 2008
is being recreated around
all this consumer debt.
Most troublesome part of that
is the naked credit default swaps.
People who have nothing
to do with the loan
betting that the loan won't be paid.
Now the reason that was a problem in 2008
was the people who were
giving the insurance
didn't have capital reserves.
- [Rob] AIG in particular.
- Yeah, but a lot of the
big banks, AIG was the one
that in September 16th,
2008, came to the floor.
They said we're 80 billion in debt.
It turned out to be 180 billion.
And that was when Bernanke and Paulson,
they let laymen fail the day before.
Panic ensued.
Everybody was gonna be rescued.
Who were they rescued by?
The US taxpayer.
Dodd-Frank passed in 2010 and the thought
was that Dodd-Frank set up transparency,
capital reserves, collateral, anti-fraud
for these kinds of swaps transactions.
What we have seen in the last few years
is the four big US bank
holding up in the swap dealers.
Goldman, JP Morgan Chase,
Citi, and Bank of America.
They have 90% of US swaps trading,
have crafted a loophole that gets them
out of all the benefits,
all the remedies that
are within Dodd-Frank.
So we're right back where we were in 2008
where not only we don't know
but the regulators don't know
what's happening out there.
- In addition I understand that in part
because of stopped buy backs and stocks
within the corporate sectors,
debt is becoming I'd say
first order of magnitude
that can't be securitized
along with the student debt--
- Absolutely, Steven
Pearlstein within the last week
wrote a really fine column,
more a reporting than a column,
in the Washington Post saying
this is the next big crisis.
Corporations, to buy back
stock, are borrowing money.
They're going into debt to buy the stock.
Well, that debt is gonna be,
there's gonna be an asset-backed security
to support that debt, it'll go
into a collateralized debt obligation,
that'll be tranched, there'll
be naked credit default swaps
where people will be betting
that corporations cannot pay that back.
And it's sort of a no-lose bet
because they are paying a
one or two percent premium
on the full value of
the payback of the debt.
In return if there is a
default of what's been bet on,
they get all the money back,
even though they never made the loan.
So yes, we were worried
about consumer debt.
Now there is a fear that there
is corporate debt out there
for which there will be defaults
and for which swaps
instruments will be triggered
which aren't adequately capitalized.
- Let's talk a little bit about
naked credit default swaps
and the history of insurance.
I remember the British situation
was such that during the Napoleonic wars,
they were trying to
insure cargo on vessels
that they didn't own and
tipping off the French.
- Absolutely.
- And then the notion of an insurable risk
required you to own property.
Why is the naked CDS tolerated
in these circumstances?
- Well, yes, and we should
say the 1806 parliament
passed a law which
became common throughout
that you cannot get insurance
on somebody else's risk.
You must insure your own risk.
Naked credit default swaps
are when you piece it,
when you peel away the onion
and get to the heart of it,
is insurance on somebody else's risk.
But they get away with it
by not calling it insurance.
In fact, in 2007,
some insurance companies were approached
to issue credit default swaps
and naked credit default swaps.
And the story is they brought out
their standard insurance contracts.
And the bank said, you can't do that.
Insurance is regulated by the states.
We don't wanna be regulated by anybody.
We're gonna call this
a swap, not insurance.
But that's what it is.
It's insuring against the
loss of somebody else's risk,
not the person who's doing the betting.
- So if I own a naked credit default swap,
can I pay you to light your bed on fire
because I benefit if
your house burns down?
- Well, the answer to that is yes.
And what we saw in the
wake of the 2008 meltdown,
Congress, especially the
Democratic party and the Senate,
was prepared to allow people
to put their mortgage
indebtedness into bankruptcy
and therefore their obligation
would be pennies on the dollar.
And that would have been
a tremendous therapy
for people who were in
mortgage default issue.
And by the way, that's bankruptcy.
That's what we do with every indebtedness.
And the Democratic Senators
went into a caucus.
They needed, I think there
were 60 Democratic Senators
at the nigh time.
They needed 60 votes to
break the filibuster.
When they came out of the
caucus, they had 43 votes.
And Senator Durbin, who
was then the minority whip
came out and he said
the banks are misplaced.
So there to effectuate the games
from naked credit default swaps,
they didn't want people to
write off the obligation.
That wouldn't trigger the default.
They wanted people to be
driven out of their homes
and legislation was passed.
You cannot put a mortgage
into a bankruptcy proceeding
and that's still the case today.
All driven by these naked bets.
- So let's talk a little bit more
about what you might call the
taxpayer being on the hook.
With these many derivatives
in the swaps world,
are they now, how do I say,
codified so we know the
scope and scale of them
but they're just not located
on the balance sheet at home?
Or are they in, how do we say, ether?
- Well, if Dodd-Frank could be followed,
they could be, there is a requirement
that if you enter into
a swap under Dodd-Frank,
it must be put in a depository
that's available to all the regulators.
And when AIG failed, or
it was going into failure
on September 16, the Fed, the Treasury,
the SCC, the CFTC, nobody knew
what the scale of the problem was.
- I remember when they said 80
and then it ended up two
and half a times that.
- Said they had an $80 billion.
By the time the bailout was
finished, it was $180 billion.
So Dodd-Frank, one of its therapies
is if you enter into a swap,
it goes into a depository,
which can be accessed by the regulators.
So they can see what's happening in--
- Didn't it also afford betting
out of exposure as well?
- Yeah, well also, for
purposes of your balance sheet,
you can net exposure.
In other words, if you're
winning on some swaps
and losing on others, you can net out,
which many prudential regulators
say causes its own form
of opaque, or opacity in this market.
But the problem is that the
banks have figured out a way
to get out from under Dodd-Frank
essentially using foreign subsidiaries
to do the transactions.
So that stuff is not going
to be in a depository.
And so what that means
when the next crisis hits,
it'll be a surprise to the regulators.
Somebody will come to their door
as AIG did and say hey, I need a bailout.
Now remember, the bailout
was paid by the US taxpayer
to the tune of trillions of dollars.
And the bailout was thought to be,
well we know this is not
a popular thing to do,
to bail out these big banks
who are stronger than ever,
but if we don't do this,
there's gonna be a systemic
break in the economy
and we will have the
second Great Depression.
- Let's talk about that.
I know about a year ago
former Treasure Secretary
Timothy Geithner gave a talk
they called the Per Jacobsson Lecture.
And he talked about the need
to fortify the bailout mechanism
'cause there were some
elements of Dodd-Frank
which inhibited, say the
Federal Reserve's right
to avoid that calamity
of a financial breakdown.
And his emphasis was on, how would I say,
you get to that crossroads and
you either bail out the banks
or you suffer a depression
of much worst cost.
And his point was don't set up a system
that forces you into the
dreadful contingency.
- Secretary Geithner is right.
Dodd-Frank makes it harder
for the Federal Reserve to do bailouts.
I think my own view is
he overstates the case.
I do think, even under Dodd-Frank,
there is still an ability
to conduct a bailout.
It's a little more restricted,
but it will happen.
And it will be if the four banks,
Citi, Goldman, JP Morgan
Chase, Bank of America
should present themselves
as being on the brink,
I believe the Feds
still has the capability
to orchestrate a bailout
which of course means
getting the US taxpayer to
be the lender of last resort.
- There are a number of
people, very sophisticated
financial officials, past and current,
who were very concerned that something
like the TARP legislation,
Troubled Asset Relief Program,
could not be passed that
members of the lower house
or perhaps of the Senate would consider it
professional suicide to
vote for another bailout
and many people I know complained
that if that can't be done,
that then resorts to the
Fed to do the bailout
because the Congress won't
appropriate the money.
But if the Fed does that,
the Fed's independence
comes into question.
People were ferocious in saying
why are you bailing out the big banks
when Ben Bernanke wasn't
lodging the balance sheet
where we're laying off
police and school teachers
not repairing our roads or our schools.
You can be buying municipal securities
and supporting all of these communities.
So they looked at that time as though,
I quote, the Fed is picking winners.
And it was the people
who made the mistakes
that brought us the financial crisis
that were being helped and
others were allowed to suffer.
This kind of stress is built up
with people like Rand Paul and others
on both sides of the aisle
are very, very anxious about,
quote, Fed independence
and whether the Fed's independence
could what you might call
endure another bailout
if TARP legislation were defeated
then it would be redounded
to the Fed, would the public,
would the legislation
tolerate the independence--
- I think that's a very, very big risk.
First of all, there will
never be another TARP.
TARP almost failed in the
House of Representatives.
They defeated it and then turned around.
Market dropped 700
points and they said yes.
But TARP was a small part of the bailout.
It was quantitative easing
that really was giving these
big banks, lending them money
at very low or almost no interest
that really was the trillions of dollars
that went to the benefit of those banks.
Secretary Geithner is right,
that's a little bit harder
to do now under Dodd-Frank
but that's what will be
sought is quantitative easing.
And you're very right.
Quantitative easing has
not been a popular program
and it's not just Rand Paul
or extreme Republicans.
Bernie Sanders and a lot of Democrats
do not the Feds should be taking all that
onto its balance sheet.
So if the Fed could get
around the minor restriction
in Dodd-Frank and go
to do this on its own,
they would be stopped dead.
Unless they could convince Congress
if you don't let us do this,
we're gonna have one-third unemployment,
we're gonna have people
selling pencils on the street.
That's the only way the Fed can
convince Congress to do this
but there is every indication.
Even conservative Republican Senators
who want to deregulate Dodd-Frank
do not wanna deregulate Dodd-Frank
for the very biggest banks
because the simple political calculus
is the banks brought the economy down.
The banks were bailed out
to the tune of trillions of dollars.
That was US taxpayer money.
A lot of those banks are stronger, bigger,
have more influence now
than they did even in 2008
and the average American
who's gonna be looked to
to do these bailouts, well,
we've had some recovery
but the recovery hasn't been uniform
and people are still suffering from 2008.
So if, I think a lot of
Senators will look at the Fed
and say, hey, you can't do this again.
And that will impact
the Fed's independence.
- Well there's a very deep converse
that if you did fortify
the bailout capacity
as former Secretary Geithner talks about,
you're also then creating the
mother of all moral hazards,
which is if you know
you're gonna be bailed out,
the temptation to take a lot
more risk ex-ante becomes,
how do we say, irresistible.
And the problem is we don't have
in the money politics of
America, a political economy
which creates prior
restraint of speculation.
The strength and intensity
of supervision and regulation
is something people hold fundraisers
to make sure it doesn't happen.
It is clearly the case that reappointment
as an SCC, CFTC,
commissioner or Fed chairman,
or even someone like the
FDIC, probably won't happen
if you are unfriendly
to the free restraint
and this is, how would
I say, always a problem,
which was when a bubble was forming,
both sides of the transaction
wanna be left alone to play.
- [Michael] Absolutely.
- It's the old McChesney Martin notion.
You gotta take away the punch bowl
just as the party gets good
in order to stabilize things.
In our political economy now,
it seems it would be almost impossible
to restrain the blowing up of the bubble
that then gets bailed out
on an even larger size.
- I agree with a lot of what you said.
I'm a little more optimistic
because I think there is a constituency,
there are large constituency
that if you explain this problem to them,
if we don't regulate properly,
you're gonna be called upon
to do a bailout and maybe that
bailout won't be available.
What does that mean?
The Great Depression.
There's a lot of hostility
to the big US banks
because they came out of the
recession stronger than ever.
Their lobbying force is fierce.
I think if there was a voice
that could articulate this problem,
we see it a little bit, Elizabeth Warren,
Bernie Sanders, and other
Democratic Senators.
I think you could put
together a constituency
that would put in place barriers
before we hit the wall and get hurt.
I think the election of Donald
Trump hurt that very badly
because now we're in the
exact opposite format,
let's do everything we
can to help the banks
and deregulate Dodd-Frank.
Query, there's a lot of debate
about how devoted Democrats
are to take in the banks
but I really think with the right voice
that a constituency, a large
constituency can be built
that would support proper regulation
of the banks to protect
against harm again.
- And at this juncture,
with the current administration,
they can't possibly want to
use that contingent liability
when infrastructure, education spending,
health spending,
environmental transformation
are all what you might call
calling on our fiscal capacity.
How can they make the
case for, how would I say,
letting be ever larger the
amount of fiscal capacity
on a contingent basis that's
reserved for the next bailout?
- Well there are two things about that.
One, you have to have some
degree of sophistication
to understand that if you give the banks
everything they want, they may fail.
And that you're gonna have
to go to the US taxpayer
to get the money back.
I don't think Donald Trump or
even Donald Trump's minions
quite has that scenario in its mind,
but more important,
they have a utopian view about the enemy.
Why are you worried
that the banks may fail?
The Fed Chair, the new Fed chair
has said I don't think banks
are too big to fail anymore.
They're not gonna fail.
We have such a thriving economy.
But there is an undercurrent
that is substantial,
well-grounded by very
sophisticated economists,
market observers, academicians,
saying things are not all that great now.
In fact, on the 10th
anniversary of the Bear Stearns
scenario on March of 2018,
Bear Stearns was March of 2008,
the Wall Street Journal was
filled with quotes saying
hey, we're building up so much debt
and the infrastructure around that debt
and there's so many defaults,
this looks a lot like the problem we had
with mortgages in 2007.
But the general consensus
is and Jerome Powell,
the Fed Chair has said this,
hey, we're doing great.
Don't worry your pretty
little head about this.
- It's like the guy
that jumps off the Empire State Building.
You open the window at the 19th floor
and say how you doing?
He says fine so far.
- (laughs) Pretty much
every crisis we've had
including the 2008 crisis was preceded
with this kind of euphoria
that everything's fine.
Let's just add on to our debt
and I think it's very
important to keep that in mind.
Because I'm seeing right now
too many influential
policymakers taking the view,
hey, 3.7% unemployment, best in 18 years.
That could go south very quickly.
I'm not saying it will go south,
but we shouldn't be euphoric about it
and we should take whatever
protections we can put in place
for a rainy day.
- So in your paper you've identified
this, what you might call a fault line,
in the regulation supervision
of the derivatives business,
of the swaps business,
you recommend closing that
and what's the process
by which that would--
- Well, that's a good question.
I should make clear that in October 2016,
the Obama CFTC saw all these loopholes
and said we gotta close them.
So it was recognized as a problem.
And they saw the swaps business migrating
out of the United States
to Europe and elsewhere.
By the way, the migration
wasn't from US banks
to not a real non-US banks,
it was from US bank holding companies
to their foreign subsidiaries
where they crafted
an exception the
Dodd-Frank would not apply.
- So if those profits turned to losses,
they'll migrate home--
- Right, well the theory is
that the banks that do this,
they deguarantee their subsidiaries,
and that they had guaranteed
for 20-something years,
to get to work an exception
that they saw in footnote 563
of the CFTC's July 2013 80 page guidance.
Wishful thinking, but
they put it into place.
In October 2016, the CFTC tried to end it
but they entered into a process,
an administrative process,
which by law would take
a year to complete.
So we could have expected by October 2017
to have these loopholes disappear
and to bring all this money
back in to the protections.
Transparency, collateral,
capital, anti-fraud of Dodd-Frank
but Donald Trump got elected
and the thinking now is
that he will and his CFTC
will not follow through, that
these loopholes are extant,
and if you worry about future crises,
the US taxpayer will be
asked to hold the bag.
Whether they will hold the
bag is another question
'cause Congress may not let that happen.
- Then the consequences
may be even more dire.
- As you've pointed out,
the consequences would be even more dire.
As I say in my paper, the
one possible rescue here
is that the commodity
statute that governs swaps
allows State Attorney General
to bring their own lawsuits,
it's got a technical Latin
name, Parens patriae,
which is on behalf of the citizens,
to challenge illegalities under Dodd-Frank
that adversely affected
the citizens and the state.
Attorney's General have
played a very active role
in going after banks for practices
that led to the meltdown or even things
that have happened since the meltdown.
They have not been
active in the swaps area.
And my hope is that the
paper will alert them
or some part of them, even one of them,
to bring their own legal action
because my view is that what is being done
flies in the face of the
plain language of Dodd-Frank.
It's an open and shut case.
But I can't go into court to do it.
One, do I have what's called standing,
can I show I'm adversely affected?
Two, I and many other
don't have the money.
These lawsuits are very, very expensive.
But the State Attorney
General could do this
and that's my one hope.
- Well, you worked for
years with the CFTC yourself
and you were the division chief there
was Brooksley Born was the Chair.
And, how would I say,
I've known you through,
obviously, the 2008 crisis to the present.
The depth of your understanding
and the intensity of your investigation
and what you illuminate for us,
even if it's not happy
news, it is a public good.
And I'm very grateful to
you for the work that you do
and I hope that we can continue
to ride on your shoulders
and elevate this conversation and bring it
to more and more people's attentions
starting with the
Attorney's General who can,
how do I say, use public
money to defend the public
and taking it more broadly to a place
where the trust and
legitimacy of our governance
and particularly our financial
governments can be restored.
- And I should say, Rob,
that at iNet Finance,
the work on my paper and
iNet's work as a whole
is a tremendous asset to those of us
who worry about preventing
future financial crisis.
So I'm very indebted to you too.
- I'll buy a naked credit
default swap on that debt.
Thank you.
- Thank you.
