Brooksley Born: The Doomsday Theorist

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The recent cry for stronger financial regulation, to the surprise of some, is nothing new. While its typical of government to take a reactionary approach to any sort of  new regulation, more than 10 years before the financial meltdown there was one voice in Washington warning about an impeding financial collapse. As highlighted in the PBS Frontline Special “The Warning”, Brooksley Born, the Chairman of the relatively obscure Commodity Futures Trading Commission (CFTC), had tried to push regulation through in the mid 1990’s that dealt with derivatives trading. She fought strong opposition to the measures, led by Alan Greenspan, Chairman of the Federal Reserve, Bob Rubin, Secretary of the Treasury, Arthur Levitt, Chairman of the SEC, and two of Rubin’s deputies: Tim Geithner and Larry Summers. At a time when the previously mentioned gentlemen were pushing hard for deregulation, Born had taken a notice to the seemingly hidden derivatives contracts that banks and corporations were entering into to hedge financial risk. These contracts were not traded on the open market and typically only the parties of the contract were privy to the terms. This non-transparent market, Born believed, represented a systematic risk to the entire financial system. She believed that if one bank or corporation were to default on one of these highly leveraged transactions, other institutions would fall like a row of dominoes. However, with the strong opposition from her considerably more powerful colleagues, this proved to be impossible. Even with the fall of LTCM, her efforts were fruitless as Greenspan played the incident off as a market anomaly. But would hard hitting regulation have stopped the crisis, or would simple transparency requirements have been enough to prevent or at least lessen the effects of the financial crisis?

I’ll defend the free and open market to my grave. I have and will continue to subscribe to the philosophy of a free economy. In this system, those who are smart and innovative are rewarded and those who are not, die off. Its like an economic natural selection. I believe that with very simple transparency requirements regarding OTC derivatives, we could have lessened the impact of the crisis. With that information available to investors, the market would have punished banks entering into riskier investments. Investors would have been aware of all transactions that were occurring. If banks or corporations wish to enter into high risk transactions and leverage themselves 30, 40 , or 50 to 1, they should be able to. However, they will have to face the shareholder and institutional investor who’s money they are recklessly trading. Should Greenspan and crew have listened to Born? Probably. Should they have let her regulatory agenda progress? Probably not. Transparency is all the market needs. Let the market work and let investors make decisions for themselves. Information will allow this to happen.

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2 Responses

  1. What is an OTC derivative?

  2. I don’t udnerstand how you can say let the market work on the basis of clear and free information flows, but then say that Born’s regulatory agenda should have been stopped even after thoughtful consideration.

    Here is a different small but important factor I find fascinating: in the 1980s, regulator’s salaries were coupled to relevant labor markets in the private sector. So, if a corporate attorney doing tax works makes say, $75,000 per year, an IRS attorney makes the same. In the name of government is always a problem and wasteful, that policy was changed.

    Now, what is more wasteful, 1) spending paltry millions to makes sure the “two teams” are roughly equal in ability to attract talent, or 2) to spend billions fixing the mess of systemic risk run amok.

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