John McCain: Crisis Enabler (Page 2)

This article originally appeared on DailyKos.com.

The combination of Gramm-Leach-Bliley and the Commodity Futures Modernization Act was a toxic cocktail whose total damage was greater than the sum of its parts. The first promoted bank buyouts and mergers that reached such an insane pitch that the average consumer could keep up only by tracking the changing names on their checks and credit cards. Mercantile buys Ameribanc and Mark Twain. Firstar buys Federated and First Colonial. US Bancorp buys Mercantile and Firstar.

And, because it allowed brokerages and insurance companies to mingle with banks, the act cemented a trend that was already (and illegally) underway, in which all those terms had become rather quaint. Is Wachovia a savings bank, an investment bank, a brokerage or an insurance provider? The answer is "yes." In allowing financial institutions to grow to Godzilla-sized proportions, Gramm-Leach-Bliley helped ensure that we would have properties that were "too big to fail." Rather than choosing to enforce rules that kept these institutions apart, the deregulators chose to create monster bankeragasurance businesses whose downfall (and existence) was enough to threaten the whole system.

But if Gramm-Leach-Bliley removed the limits on size and scope, these new institutions still needed fuel. With many financial transactions operating on razor-thin margins, and increasing automation sapping the profits from trading of all sorts, they needed a new way to generate the funds required to swallow their brethren in the merged fiscal corporation pond. For that, the Commodity Futures Modernization Act was a godsend.

Among those instruments which the CFMA sheltered from regulatory scrutiny was something called the "credit default swap." A kind of insurance one bank could exchange with another, credit default swaps supposedly made it safe for banks to take on ever riskier forms of debt. The act didn't invent these swaps, though they were relatively new. But the act meant that they would be not only unregulated but almost perfectly opaque, thus placing the swaps in a hyper-rich growth situation. No one had any idea what these things were actually worth; they were traded "over the counter" without being administered by any exchange, and even the SEC could monitor their existence only indirectly.

So who would love a new kind of financial instrument that was difficult to understand, invisible to regulators, and impossible for even the whizziest of Wall Street whiz kids to value? Guess.

More recently, instruments that are more complex and less transparent--such as credit default swaps, collateralized debt obligations, and credit-linked notes--have been developed and their use has grown very rapidly in recent years. The result? Improved credit-risk management together with more and better risk-management tools appear to have significantly reduced loan concentrations in telecommunications and, indeed, other areas and the associated stress on banks and other financial institutions.   --Alan Greenspan, 2002

Get that? Greenspan loved credit default swaps. He opined again and again that such instruments would be the salvation of the industry by spreading around risks. To the mighty Greenspan, both their complexity and their lack of transparency were good things, since swaps would only be handled by the big boys who knew how to play with fire.

When questioned about his support of Gramm's legislation, John McCain called his friend (and by then, campaign co-chair) Gramm "one of the smartest people in the world on the economy" and pointed out that Greenspan also favored the acts Gramm and his coalition of lobbyists had authored. If both Gramm and Greenspan were on his side, McCain couldn't possibly be in the wrong.

Except, of course, that he could.

From the beginning, there were plenty of people in the financial community whose opinion of these unregulated credit swaps was not as rosy as that of Gramm, Greenspan and McCain. Chief among those speaking in opposition was SEC Chairman Arthur Levitt. Levitt argued that what the industry needed was more transparency, especially when it came to complex instruments like default swaps, and he testified to this before Gramm's Senate Banking Committee,.

In my judgment, the risk of this regulatory approach is simply unacceptable for America's investors.   --Arthur Levitt, 1999

Gramm paid no attention.

Credit default swaps did allow the banks to share risks. So much so, that banks raced each other in an effort to find more risks. They made it possible for the down payment on homes to become 3 percent, 1 percent, 0 percent. Skip the credit check, avoid the employment requirements, damn the torpedoes, full speed ahead! We've got a credit default swap, we can do anything!

The encouragement and "safety" that credit default swaps provided made the subprime mortgage market possible. Just as with the deregulation of S&Ls in the 1980s, the market provided a flood of easy credit. The result was a real estate boom, soaring home prices and a plague of Flip that House! shows on cable.

As the banks piled up crappy mortgages, they heaped on ever more of the credit default swaps--and they still had no idea how to value the things. Worse, they began to trade the swaps themselves as if they were an investment, treating them like something worth holding instead of a big bundle of cartoon bombs whose fuses were already lit. Since very few loans were falling into default at the time, owning a default swap seemed like a way to collect fees without ever paying. Banks wanted more, and more, and more.

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