How the Private Sector Outsmarts Regulators

A common thread runs through the two biggest crises of our present era: the financial catastrophe of 2007–09 and the ongoing gulf oil spill, which now ranks as the worst in U.S. history. People who work for private companies—particularly those in high flying, high-tech industries like Wall Street and Big Oil—tend to outsmart the people in government who are supposed to be watching them. In the case of Wall Street, we now know that an entire generation of regulators was bamboozled by Street whizzes who sold them on everything from the irrelevance of Glass-Steagall to the low-risk benefits of unmonitored derivatives trades. The major oil companies, if anything, did an even better job of fooling one and all in Washington that they knew what they were doing with deepwater drilling. "We were sold a bill of goods by BP and other oil companies going back several administrations," said Rep. Frank Pallone (D-N.J.), who has vociferously resisted Barack Obama's efforts to expand offshore drilling. "During the whole time I've been in Congress, the big oil companies have been telling us they can drill as deep as they want without risk."

Now that all this corporate hubris has met its nemesis, you might think that Washington finally has caught up with the fact that it can't catch up. But in truth Washington is in danger of falling behind once again. Especially when it comes to Wall Street, where the fixes are much further along, both the Obama administration and Congress seem content to leave many of the critical details—on the amount of leverage banks can take and the capital they must keep, on what kind of trading will be allowed and where—up to present and future regulators. Our government fixers are determined to draw perishable lines in the sand and to avoid legislated lines in concrete, like Glass-Steagall's separation of investment from commercial banking (or, in the closest thing to it in the current legislation, Sen. Blanche Lincoln's proposed spinoff of derivatives desks from banks, which seems to be losing support daily). Their argument is that, as Tim Geithner, President Obama's self-assured Treasury secretary, put it in a letter back in January about proposed new limitations on leverage taken by banks, setting such things down in writing might endanger banks' future business. "We do not believe that codifying a specific numerical leverage requirement in statute would be appropriate," he wrote. Doing so, Geithner suggested, would "produce an ossified safety and soundness framework that is unable to evolve to keep pace with change." And change, of course, is good—the mantra we heard for so long during the era of financial innovation.

This attitude is, oddly enough, one pitfall of having a smart cookie like Obama in the White House. Obama is just smart enough to convince himself that he and his successors in Washington can keep up with these guys in the future, no matter what the past suggests. Certainly Geithner (one half of a mutual "man crush" with Obama, if New York Magazine is to be believed) and the president's chief economic adviser, the ostentatiously brainy Larry Summers, have pressured Congress to leave as much to regulators' discretion as it can. The problem with this approach is that regulators can easily undo regulations with little public debate, depending on which way the political and ideological winds are blowing. And, let's face it, really tough and intelligent regulators are the exception rather than the rule. Agencies that are powerful in one era—for example, the Securities and Exchange Commission under Stanley Sporkin, its singularly aggressive chief enforcer in the '60s and '70s—often prove to be pushovers and patsies in another era, as the SEC was under multiple directors during most of the '80s, '90s, and 2000s.

A quick history of a couple of decisions made at the Commodity Futures Trade Commission is illustrative. In 1993, just before she left the CFTC chairmanship to join Enron's board, Wendy Gramm issued two seemingly innocuous exemptions to rules governing over-the-counter derivatives trade. Gramm was a passionate deregulator—Ronald Reagan once described her as "my favorite economist"—and so the Wall Street lobby found it was pushing on an open door with her and her board. No one heard about or second-guessed the internal CFTC discussion (at least until one of Gramm's later successors, Brooksley Born, came along). One of Gramm's new rules permitted so-called hybrid instruments to be treated not as futures and options—which the CFTC controlled—but as securities or debt obligations. Since they weren't futures or options, that effectively made them exempt from any regulation at all. Gramm's other new rule exempted from regulation some OTC "swaps" between companies as long as the deal was "customized," or simply agreed to privately between two companies. As we now know, Wall Street later stormed like an invading army through that loophole, declaring trillions of dollars of trades to be customized even when they were often traded on the open market.

It's not that there aren't any hard-and-fast laws getting passed. Obama administration and Fed officials, for example, insist that under the Senate bill, regulatory discretion to save a failing financial firm is dramatically narrowed, not widened. Take Section 13.3 of the Federal Reserve Act, enacted during the Great Depression to allow the Fed to provide liquidity in case of market panics. The old rule allows the Fed to make secured loans to any individual company or partnership in order to rescue it—as long as the firm has sufficient collateral. The rule was applied in 2008, controversially, to facilitate the emergency takeover of Bear Stearns by JPMorgan and to purchase the infamous toxic collateralized debt obligations from AIG at full value, making whole Goldman Sachs and a slew of other counterparties that later engorged themselves with record bonuses. Such uses of Section 13.3 engendered endless rounds of debate about "moral hazard"—the idea that major firms would take future risks with taxpayer money because they had been deemed too big to fail. But under the new legislation, Section 13.3 is rewritten so that the authorities are expressly forbidden from saving individual firms. The Fed is permitted—subject to Treasury's approval—only to provide liquidity for the system as a whole under broad-based programs, like the Troubled Asset Relief Program of 2008. And the new law gives Congress's General Accountability Office the authority to monitor such a program to ensure that it is not intended for individual firms, which are also subject to easier liquidation under a new "resolution authority."

That's all very reassuring. But it's still mainly a way of dealing with firms once they go bad, rather than a law that tells Wall Street what it can and can't be, thereby preventing banks from veering off a cliff once again. And that's what is missing from the current legislation, except for Senator Lincoln's fast-fading idea. Glass-Steagall was a law of dubious provenance; it stemmed from the 1934 finding by the Pecora Commission that banks were misusing their securities affiliates, touting bad stocks to customers to help create a bubble. Later academic studies, however, showed there wasn't much evidence of that after all. Even so, Glass-Steagall remained the law of the land for 60 years or so and helped create islands of safety in the banking system that remained uninfected during previous crises (it's hard to remember that Citibank was once considered a fairly conservative institution). So sure, hard-and-fast codes could become "ossified." But that could be taken to mean that Washington might be imposing a real structure on Wall Street—a legal framework that will keep some parts of the financial system from getting mixed up with other parts.

If you don't have the brains to keep up, at least provide some backbone.

Michael Hirsh is also the author of At War with Ourselves: Why America Is Squandering Its Chance to Build a Better World.