By Martin Breen
You probably haven't thought about Enron in a while - I know I haven't. In the first version of Enron, they stole billions from Californians and helped create the State's blackouts in the early 2000's by manipulating electricity prices. In the second version of Enron, they famously went bankrupt when it was revealed that they had very few actual assets and were criminally inflating earnings. Then finally in the third version of Enron, which only recently came to light, they indirectly helped create our current financial crisis.
In a December 2000 email to Ken Lay and Jeffrey Skilling (yes, the same guys currently serving time), Enron Lobbyist, Chris Long, said the following about the Commodity Futures Modernization Act of 2000 (CFMA): "Enron was a leading advocate of the passage of this legislation." You know, if Enron was involved, this will not end well. But I am getting ahead of myself.
The CFMA is a little known, and little debated Act signed into law by Bill Clinton in December 2000 as he was headed out the door that essentially exempted financial derivatives from government regulation by the SEC or anyone else for the matter. The CFMA also prohibited the States from regulating these instruments. While I am not an economist or expert on the subject, I did stay at a Holiday Inn Express last night so I will try to explain how all this fits together.
The CFMA opened the door to unregulated trading of "credit default swaps," one of the financial instruments blamed by many for creating our current crisis (the other is collateralized debt obligations, such as mortgaged-back securities). At their simplest, "credit default swaps" are insurance contracts bought to protect against losses of the underlying asset. For example, those financial institutions that bought the mortgage backed securities hedged this risk of default of the underlying assets (i.e., mortgages) by buying a contract that would make them whole should the asset suffer loss.
Bailout king and insurance giant, AIG, sold these credit default swaps like cans of soda. Indeed, many experts believe that without the creation of the market for credit default swaps, that mortgage backed securities, would not have grown to a $60 trillion market, nearly twice the size of the Stock Market. Put another way, without these "credit default swaps" even Mount Everest climbing Wall Street types would not have been able to grow this new market because mortgage-backed securities would have never gotten AAA ratings. This in turn fed air into the housing bubble as risky borrowers were now allowed to obtain mortgages, even without a job.
But like everything on Wall Street, the whiz kids took it one step further, taking this insurance contract and selling it on the open market. They called this new breed of credit default swaps, "naked" swaps. It was a naked swap because unlike an insurance contract where the person buying it has some risk or exposure, i.e., they could lose money on the deal; the "naked" credit default swap was really just a bet against someone else's failure. Indeed, it was the ultimate form of shorting.
And, ultimately, "naked" swaps dominated this new credit default swap market. In most States, "naked" swaps were considered gaming and therefore either regulated or prohibited entirely. Of course, had it not been for the CFMA preventing the States from regulating this market, "naked" swaps would have still been considered gambling. After Clinton signed the CFMA into law in 2000, the betting began in earnest and the market grew from $900 billion to $60 trillion (remember a trillion is a thousand billion and a billion is a thousand million).
The other important part to understand about these "credit default swaps" is that they are not regulated insurance contracts in the sense that there are not any capital reserves protecting the other party. In real insurance contracts, regulations require that insurers keep capital reserves in a sufficient amount to guarantee the potential loss. In these credit default swaps, there is no money backing the contract so if the loss happens; the contract is only as good as the solvency of the company backing it. It is for this reason that the Government pumped over $180 billion into AIG. And, it is for this reason; the company after company that was involved in this market has liquidity problems, which led to the credit freeze.
So at the end of the day, these credit default swaps that were designed to hedge risk (reduce it), instead ended up multiplying the risk as people placed bets about the credit worthiness of certain bonds and loans, including mortgage backed securities. Of course, once the housing bubble burst, these huge profits quickly turned into huge losses. The losses mounted and triggered the credit default swaps which triggered another round of huge losses. It was like a ponzi scheme but in reverse.
So how and why did Enron get the CFMA passed? Enron did what all big, successful companies do, it bought itself access through career politician, former Senator Phil Gramm (and his wife Wendy Gramm just happened to be an Enron Board Member), who threw his considerable political weight around to get the CFMA attached to a 11,000 page appropriations bill with virtually no debate at all. What started as a way to deregulate certain electronic trades ended up deregulating these new financial instruments? So as a new millennium began, the ticking time bomb had been set.
The fact that Gramm's wife was on Enron's Board should have set off alarm bells in Washington that the fix was in and someone should have put a stop to it. At the very least, there should have been a debate and a vote on the 262 page bill by itself. But this is the way the game is played and Gramm was a master at playing it. Come on folks, how many dots do you need connected before you see the picture - career politicians are causing our downfall.
If you're still not convinced, let me throw one more little factoid at you. In 1998, Brooksley Born, Chairperson of the Commodity Futures Trading Commission, was steadfastly against these unregulated financial derivatives declaring that "an unregulated derivatives market . . . could pose grave dangers to our economy." When her opposition became too intense, she was forced to resign to a more pliable Commissioner. Ironically, President Clinton's economic dream team of Alan Greenspan, Robert Rubin, Arthur Levitt and Larry Summers (one of Obama's current advisors), are alleged to have helped oust Ms. Born.
And, though I did not intend on mentioning Elton Gallegly, I do so because his name magically appeared when I reviewed those career politicians who voted for the CFMA. Even though the vote was not partisan - please notice that Bill Clinton signed the Act - the Republicans were only too happy to deregulate the markets. Elton Gallegly was not any different and he gladly voted for the CFMA. So when Gallegly (or Clinton) say they had no responsibility for our current problems, please remind them of their vote on the CFMA.
In fact, this goes to a larger point about political parties and the danger of always voting your party line. Here, I am sure that Gallegly did not intend on creating the pathway to our current crisis but had he paid closer attention to the details, had there been any debate at all; maybe this deregulation (a Republican mantra) may not have happened. Indeed, I never understand why Republicans don't trust big government yet completely trust big business. This seems logically inconsistent. Here's a conservative principle: How about we don't trust either, especially when Enron's involved?