Frontline – The Warning

Watch the hour-long retrospective which aired last night on PBS’s Frontline.  It should be very enlightening in regards to the seeds of the bubble and meltdown.  It examines who the players in the 1990s and 2000s were, what their attitude to regulation was, and how lax regulation created a bubble and a bust.

Also see the following posts for more background:

(video was to be embedded below, but I cannot get it to run on Naked Capitalism; Here is a link to Frontline for the video which runs just under one hour)

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About Edward Harrison

I am a banking and finance specialist at the economic consultancy Global Macro Advisors. Previously, I worked at Deutsche Bank, Bain, the Corporate Executive Board and Yahoo. I have a BA in Economics from Dartmouth College and an MBA in Finance from Columbia University. As to ideology, I would call myself a libertarian realist - believer in the primacy of markets over a statist approach. However, I am no ideologue who believes that markets can solve all problems. Having lived in a lot of different places, I tend to take a global approach to economics and politics. I started my career as a diplomat in the foreign service and speak German, Dutch, Swedish, Spanish and French as well as English and can read a number of other European languages. I enjoy a good debate on these issues and I hope you enjoy my blogs. Please do sign up for the Email and RSS feeds on my blog pages. Cheers. Edward


  1. Braywolfpacker

    The frontline documentary was a good piece. One aspect they missed, however – the 90’s were good years for the financial world, IT world, and internet world. Not so good for “brick and mortar” US manufacturing sector.

  2. PT

    This video leaves one question – really the only question – unanswered: how exactly could regulation have been crafted to prevent any of the negative events described? The inability to answer that question throws the entire premise of the video – that lack of regulation is the primary factor behind current or past financial crises – into question.

    Furthermore, they never explore how regulation of private, one-off contracts could be accomplished, or if it’s even desirable. It’s likely easy for most to accept this type of interference in the context presented (multi-billion dollar “derivatives”)….but I think it quickly becomes a problem when you consider the full implications. It’s difficult to envision a law that could regulate what we call OTC derivatives that doesn’t also give the gov’t the authority to insert itself in every private contract.

    1. Head

      Regulate OTC exotic derivatives like futures and options. Standardized contracts traded on an exchange. Why are they really traded OTC anyway?

      As you know, the purpose of bank regulation is to promote prudence and reduce systemic risk. Traditional methods include
      large reserves
      limited leverage
      strict lending standards
      central counterparty clearing (even for exotic derivatives, man)
      transparent accounting.
      If traditional regulatory methods were applied to all financial entities and enforced over the past decade, then I maintain that catastrophe would have been averted.

      1. PT

        “If traditional regulatory methods were applied to all financial entities and enforced over the past decade”

        What “traditional regulatory methods” would have prevented the latest crisis? We have a credit crisis every 10-15 years, regardless of the regulatory structure in place at the time.

        There a numerous reasons that a lot of these transactions happen outside of an exchange, but one of the most important is that their is no active market for the type of transaction needed. Customization. People think in terms of futures, options – even so-called exotic derivatives when discussing this…but the problem is in dealing with contracts that are specific customized agreements between two parties…re-insurance companies for example. How do you bring that on to an exchange? And if you can’t, how do you write a law that distinguishes between what is illegal outside of an exchange and what is not?

        1. Head

          Regulating reserves, leverage, lending standards, accounting would have prevented the current catastrophe. I thought this crisis was primarily caused by defaulting mortgages that killed MBSs made from them that killed derivatives derived from those that killed leveraged opaque Enron-esque balance sheets that lacked adequate reserves that etc.

          The reinsurance industry had nothing to do with the current crisis. There was no credit crisis in the US between 1940-2007. The great moderation was probably a consequence of reasonable regulation, which was eroded in the 1990s and 2000s. Inadequate regulation increases systemic risk.

          Your point about contracts is interesting, but that is only a part of regulation. Monitoring markets and participants to ensure that counterparties can meet their obligations is reasonable regulation, even if customized contracts are traded OTC.

          1. PT

            “Regulating reserves, leverage, lending standards, accounting would have prevented the current catastrophe.”

            I completely agree with you here – but you’re talking about bank regulation here, not OTC derivative market regulation. Disclosure requirements for banks could easily be increased to give investors (and regulators) a better view on a bank’s exposure – but forcing derivatives into standardization doesn’t really do much to help transparency.

            Derivatives contracts are entered into by a variety of entities other than banks…which is what I was trying to get at by bringing up reinsurance. The point I was trying to get across was that if you want to kill the OTC market there are ramifications extending far beyond banks.

  3. chad

    I understand the episode was suppose to focus on Born but did I just miss it or was 9/11 not even mentioned? Wasn’t that a driving factor for decisions that led to where we are now?

    I’ve always considered myself in the free-markets-are-best camp but even I can see how there has to be rules to the game. When it was reported Greenspan said to Born that even fraud should be sorted out by the free market I was amazed. I just can’t get my head around the idea that a market can efficiently identify and expose fraud. Surely there’s evidence prior to Madoff and prior to Greenspan making the comment to the contrary right?

    1. PT

      I agree, but I think there were a lot of important topics that were left out of the discussion – the “ownership society” & Fannie/Freddie push for one. The piece seemed to suggest that regulation of the OTC derivatives market would have prevented the mortgage boom & bust…which is laughable.

      Also, I think it should be pointed out that fraud is explicitly illegal in any transaction. Frontline framed it in a way that seemed to suggest that fraud is ok in the derivatives market. I think the real issue is how to to prevent fraud ex-ante – which is difficult.

      The example they used to P&G vs. Banker’s Trust…ironically that was a case where the market did sort itself out, P&G sued BT. Sure, it would be great to prevent this from happening in the first place, but I’m not aware of any regulation that could be written that could have prevented that from happening, and I think that was the point Greenspan was trying to make in the clip of him in front of Congress. The best thing we can do is have very stiff penalties (jail time) instead of the slap on a wrist that white collar criminals too often get.

      Furthermore, P&G is a multi-billion company itself, with its own massive finance department – I’m not sure taxpayers should be paying to protect them from making dumb mistakes.

    2. Tao Jonesing

      Born was a Clinton appointee who left the job in 1999.

      9/11 happened on W’s watch (i.e., after Born’s experiences). That’s why 9/11 was not mentioned: it hadn’t happened yet.

      1. chad

        I realized that but I don’t see how you can draw any conclusions about the relationship between Born’s warnings and now without at least addressing the impact of 9/11 on Greenspan’s thinking.

  4. ian

    PT says:
    “…a law that could regulate what we call OTC derivatives that doesn’t also give the gov’t the authority to insert itself in every private contract.”

    Um, the government regulates private contracts now, does it not? They still teach courses in “contract law” last time I checked. Did I miss something?

    1. PT

      Well yes, I think you are missing something. I’m not a lawyer, so please correct me if I’m wrong, but contract law is a common law concept that gives either party to contract judicial recourse if contract is breached. In the US, and other common law countries, a contract is void if violates the common law statute of frauds. Derivative contracts are obviously included under contract law, which is why P&G sued Bankers Trust as depicted on Frontline – probably for something like fraudulent conveyance.

      But this concept has little to do with regulatory bodies set up through legislative action to prevent legal contracts from taking place because they don’t like the transaction.

      The point of this is – how exactly do you write a law to regulate these contracts? I.e., what exactly defines a derivative? And once you write the law defining an “OTC derivative”, how do you prevent companies from just altering the face of the transaction to stay outside of the regulatory requirements? It seems to me you would have to give gov’t the implicit authority to stand between two parties in every single private contract to accomplish that.

      1. csissoko


        Speculative transactions (i.e. those where neither party was protecting itself against an existing economic risk) have always been consider wagering contracts. In the 19th century — after plenty of experience with the behavior of derivatives on financial markets — legislators and jurists changed the law to make wagering contracts unenforceable unless they were traded on exchange.

        The golden age of western growth took place with unenforceable derivative contracts. What evidence do you have that recent changes in the law (i.e. the CFMA that was passed in 2000 to prevent the CFMA from doing its job) are an improvement?

        1. PT

          I’m not sure I quite follow the point you’re trying to make. Usually not possible to distinguish between types of transactions – a hedge vs. speculation for example. The only difference between the two is intent – so to prove something is not a hedge seems quite arbitrary. To give a regulatory body the power to make this determination seems to me to be affording them the ability to step into any contract.

          Anyway, I still fail to see how any of this could have prevented any of the crises discussed.

          1. csissoko

            The distinction between indemnity contracts and wagering contracts dates back to the 16th century. The lines are of course not always clear, but there’s a huge body of existing law that addresses these issues.

            I don’t understand why anybody would think that derivatives contracts should be exempt from common law (and legislation that grew out of common law principles) that developed over centuries of experience.

          2. csissoko

            “I still fail to see how any of this could have prevented any of the crises discussed”

            Well, you’re in good company, but basically the problem is that financial assets are all related to money. Whenever you let credit grow in an unconstrained manner, you’re going to end up causing either common inflation or asset price inflation.

            One of the many goals of constraints on speculative financial contracts in the past was to keep asset prices and inflation from getting out of line. In 2000 the constraints were removed and by 2007 we had the mother of all asset price bubbles. The details are too complicated for a comment.

        1. PT

          “…the problem is that financial assets are all related to money. Whenever you let credit grow in an unconstrained manner, you’re going to end up causing either common inflation or asset price inflation.”

          Yes, that’s obvious, but what does this have to do with regulating derivative contracts?

          “….In 2000 the constraints were removed and by 2007 we had the mother of all asset price bubbles.”

          As if we’ve never had a credit bubble in the past? You’re conflating two issues. Asset price/credit bubbles have been a common occurrence long before 2000. This has nothing to do with derivatives – banks don’t need derivatives to create credit/money. They may have been one of the latest tools used to speculate, but not a cause.

          1. PT

            “I don’t understand why anybody would think that derivatives contracts should be exempt from common law”

            I really don’t understand what you are suggesting. I don’t think derivatives are or should be exempt from common law. In fact, as i said earlier derivative contracts are clearly subject to contract law (which = common law). Is it that you believe that derivative instruments fall under the subheading of Wagering Contracts, and therefore derivative contracts should be illegal? I have a difficult time finding that a convincing argument, particularly considering the negative implications for things such as basic currency markets.

          2. csissoko

            PT: It’s extremely clear that some derivative fell under wagering laws and some didn’t. Until the CFMA of 2000 that was an issue to be decided in the courts if derivative players were careless enough to get themselves into a legal dispute. That’s how common law has been applied to financial contracts for centuries.

            In 2000 Congress decided to give derivatives special treatment under common law by exempting them from wagering laws. This is a change to centuries of legal precedent.

            “what does this have to do with regulating derivative contracts?” Derivatives are financial contracts. Excessive growth of derivative contracts will cause some kind of inflation just like excessive growth of any financial contract will do. Keeping the growth of financial contracts in reasonable bounds is crucial to the healthy progress of any economy.

            If the housing bubble had started to deflate in 2004/2005 when the Fed started raising interest rates I would have said that it was a “normal” bubble. The fact that financial innovation (using derivatives/synthetics) managed to keep money flowing into the housing market when fundamentals had turned against the market is evidence that this was not a normal, Minskian bubble.

          3. PT

            “It’s extremely clear that some derivative fell under wagering laws and some didn’t. Until the CFMA of 2000 that was an issue to be decided in the courts”

            I understand this, but the argument you’re making requires the leap that pre-CFMA the growth in (mortgage) derivatives that you say caused the (housing) bubble would not have been able to happen – presumably because they would have been illegal. I just don’t see why this would be the case, and would think that the CDO market (or whatever other swap-type market would have evolved) would likely have grown just as fast without the CFMA.

            The CFMA was more a symptom of what was pervasive at the time than a cause of the bubble – I have a hard time seeing how the CFTC would have been able to prevent what happened.

            Even if we leave aside whether or not these products would have been able to grow, I’m still not convinced that this bubble would have been avoided. I’m not convinced that this was not, as you say, a Minskian-type bubble – I don’t see it as surprising that the bubble did not begin to deflate from 2005. Isn’t that classic Minsky, that the ponzi-type lending and asset price inflation are self reinforcing?…i.e., relatively small & short-lived interest rate hikes to 5% was not nearly enough to outweigh the deceptive appearance of deleveraging caused by inflating asset prices.

          4. csissoko

            My view is that it was the synthetic and synthetic tranches of hybrid CDOs that sustained the market in its later years. (Approximately 50 – 60% of CDO tranches were synthetic in 2006-7.) Without synthetic tranches to raise yields for investors these deals would have been uneconomic.

            The CDS contracts used to make these synthetic CDO tranches are precisely the contracts that the CFMA was designed to protect from gambling laws. CDS notional doubled every year from 2001 thru 2007 growing from 1% of the OTC market to 16% of it.

            With this data and the direct connection between CDS, CDOs and the mortgage/leveraged loan market, the claim that the bubble would have happened without CDS seems kind of bizarre.

          5. PT

            “My view is that it was the synthetic and synthetic tranches of hybrid CDOs that sustained the market in its later years.”

            But isn’t this just fancy way of saying that more & more leverage continued to drive asset prices higher & higher? Was synthetic CDO structures the cause of the bubble, or is it possible it was just the path of least resistance to getting leverage?

            “The CDS contracts used to make these synthetic CDO tranches are precisely the contracts that the CFMA was designed to protect from gambling laws.”

            That may be true, but CDS certainly existed before 2000. (On a side note – and I’m sure you know more than I do about specific products – but could the same basic result have been achieved using something like a TRS?) Anyway, maybe I’m wrong, but I still fail to see how the CFTC could have stopped the leveraging even without CFMA. I’m still skeptical that the leverage wouldn’t have been there, if not in the form of partially funded synthetic CDOs then something else. You make it sound like the “products” themselves drive credit risk, when in reality it’s some investor buying that risk.

          6. csissoko

            There’s the crux of our difference then: You believe that investors demand “leverage” and it will be created independent of what credit instruments are legal. I believe that the classes of credit instruments that are legal is a crucial determinant of the amount of leverage in an economy.

            In fact I would argue that a fundamental purpose of anti-wagering laws in the 19th century was to control the quantity of financial contracts, the amount of leverage in the economy and thereby keep a lid on prices.

          7. PT

            Thanks for the interesting conversation – I learned a few things.

            You are right – I do believe that it’s investors’ demand for leverage that primarily drives credit cycles, and that demand is at least in part driven by investors’ perception of risk. I do see how availability of products can make it easier to obtain leverage though, but remain skeptical that it is a primary driver of an investor’s desire to lever up.

      2. Yakkis

        The government makes all kinds of contracts void when they don’t like the transaction. Try enforcing a contract for slavery, prostitution or even a contract of non-competition for indefinite duration.

        1. K Ackermann

          Contracts that adversely affect a 3rd without their knowledge are not valid contracts.

          When a contract is written using notional values that cannot be paid by the issuer, then did that issuer intend all along that a 3rd party (the public) would shoulder all the risk?

          I ended up paying for those goddamn things!

          If we don’t get our arms around those kinds of contracts, then blood will flow, and we won’t have any contracts. They will be relegated to quaint.

          1. PT

            “Contracts that adversely affect a 3rd without their knowledge are not valid contracts.”

            Really? Don’t most business contracts adversely affect competitors?

            I think the problem you’re talking about is too big to fail…if you want to prevent “gov’t sponsored” institutions from dealing in certain securities that’s one thing, but to effectively put a regulator in every contract is not a viable solution.

  5. Jesse

    The objections of PT are just silly really.

    You limit who can engage in one off contracts, and you set tighter restrictions on capital requirements.

    It is the same question that is dealt with when the financial regulators consider ANY widely traded group of financial instruments.

    Oh no it can’t be done with these because these are DERIVATIVES!!! Back off. You don’t understand them.

    Well, bollocks.

    1. PT

      Sorry Jesse, but your argument really holds no water whatsoever. “limit who can engage in one off contracts”?? Almost every business transaction is a one off contract. I sign a contract with my supplier to buy X amount of whatever he produces. You want to limit that???

      I assume no, so maybe you mean you can try and limit it to one off “financial” contracts only. But what makes a contract a financial contract vs. a nonfinancial contract? Does every private contract have to get cleared through some regulatory body before being executed??? I assume that’s not what you’re trying to suggest, but how do you accomplish what you seek to do without giving that power to a regulator?

      Capital requirements? What capital requirements? For who? Are you going to impose some sort of capital requirement on Proctor & Gamble if they enter into a contract with a German Bank? Or how about P&G entering into a contract with a hedge fund located in Bermuda? Please tell me how you could accomplish this.

      “It is the same question that is dealt with when the financial regulators consider ANY widely traded group of financial instruments.”

      Actually, it’s not – and that’s the problem. Private customized derivative contracts aren’t any more widely traded than the private contract P&G signs with Wal-Mart to deliver toothpaste.

      1. DownSouth


        I don’t normally respond to the nonsense of fools, or to their apologies in justification of immoral behavior. But in your case I’m going to make an exception.

        In all that smokescreen you throw up, trying to make it seem humanly impossible to regulate derivatives, I find it incomprehensible that you would invoke such a thing as the “private contract P&G signs with Wal-Mart to deliver toothpaste.”

        All I can say is: “What frigging planet do you live on?”

        Is it possible that you have never heard of Upton Sinclair or The Jungle? Is it possible that you are unaware there exists an entire world of consumer regulation out there that protects consumers and guarantees the safety of things like toothpaste?

        And is it possible you can be so incredibly, amazingly ignorant as to what happens when that safety network fails, or when it is corruptible or non-existent as in countries like China?:

        Let me assure you that human beings are intelligent enough to figure out how to regulate derivatives or any other part of the financial services industry. The only thing lacking now is the moral and political will.

        1. PT

          Thanks for pointing out my ignorance. Judging by you’re intelligent comment you clearly have a superior understanding of what is being discussed here.

          I’ve not made one mention of anything related to consumer protections, etc, etc. The issue is whether or not OTC derivative products could be regulated without interfering with the ability of businesses to enter into legitimate contracts.

  6. bobh

    Those insisting that regulation would have been an imperfect tool to prevent the derivatives mess have a point, although it is easy to see how some regulations(or simply leaving Glass-Steagall in place) would have reduced some of the worst excesses. Smart guys who are figuring out ways to get rich using leverage to game the system might be a little more cautious if they understood that they were inventing strategies not just to outsmart other smart guys but to get around laws that set up to make risk more transparent. One can dream. What was and is needed, however, is both regulation and restructuring of the financial industry so that the government isn’t forced to make gamblers whole when they go bust and the smart guys and their corporate sponsors have to take real, substantial losses when they crash the economy. This change, however accomplished,would do a lot to make markets price risk more accurately, thereby reducing the severity of bubbles and disasters-waiting-to-happen. Unfortunately, it seems as if the banks’ lobbyists will be able to keep this from happening until after the next crash.

    1. PT

      I agree with most of what you’re saying here. The consistent gov’t bailouts of failed institutions just encourages the excessive risk taking they keep claiming they want to prevent.

      I’m not sure how I feel about Glass-Steagall – I mean, it was pretty much an irrelevant reg long before it was officially repealed, no?

      Along those lines though, I think one of the primary problems we have is the moral hazard created by deposit insurance…we should have more stringent restrictions on the use of gov’t insured deposits…materially higher reserve requirements for one and stricter limitations on what qualifies as reserve assets for deposits. The excessive swings in credit creation – and the massive implications of its collapse – seem to me to be at the heart of the problem. Reduce the ability of the banks to take large risks and leverage endlessly on top of deposits and maybe we wouldn’t have the need to be bailing out failed banks. We need to get to a place where any institution can be put into receivership without bringing down the system, and simply breaking the largest banks up into pieces really doesn’t address the underlying problem.

  7. DownSouth

    What a superb program!

    That said, however, I nevertheless wish that it would have delved a little more into the underlying dogmas and pseudoscience that underpin the philosophies of Rand, Greenspan, Rubin, Summers, Bernanke and Geithner.

    “A consistent pessimism in regard to man’s rational capacity for justice invariably leads to absolutistic political theories,” Reinhold Niebuhr cautions us in “The children of light and the children of darkness”; “for they prompt the conviction that only preponderant power can coerce the various vitalities of a community into working harmony.”

    And there can be little doubt as to how Niebuhr would have judged Rand, Greenspan, Rubin, Summers, Bernanke and Geithner: “the moral cynics, who know no law beyond their will and interest, with a scriptural designation of ‘children of this world’ or ‘children of darkness’. “

    “This is no mere arbitrary device,” Niebuhr goes on to explain; “for evil is always the assertion of some self-interest without regard to the whole, whether the whole be conceived as the immediate community, or the total community of mankind, or the total order of the world.”

    Martin Luther King was to pick up on and greatly elaborate upon the “children of darkness,” their pessimism concerning man’s moral and rational resources to achieve fairness and justice:

    Plato, centuries ago said that the human personality is like a charioteer with two headstrong horses, each wanting to go in different directions, so that within our own individual lives we see this conflict and certainly when we come to the collective life of man, we see a strange badness. But in spite of this there is something in human nature that can respond to goodness. So that man is neither innately good nor is he innately bad; he has potentialities for both. So in this sense, Carlyle was right when he said that, “there are depths in man which go down to the lowest hell, and heights which reach the highest heaven, for are not both heaven and hell made out of him, ever-lasting miracle and mystery that he is?” Man has the capacity to be good, man has the capacity to be evil.

    And so the nonviolent resister never lets this idea go, that there is something within human nature that can respond to goodness. So that a Jesus of Nazareth or a Mohandas Gandhi, can appeal to human beings and appeal to that element of goodness within them, and a Hitler can appeal to the element of evil within him.
    –Martin Luther King, “Love, law and civil disobedience”

    What we saw beginning about sixty years ago was the rollout of a full court press by the children of darkness. It pervaded every aspect of our thinking lives—art, science, religion, economics and politics. And the New Atheist Ayn Rand was undoubtedly the high priestess of the paladins of selfishness and greed.

    But she has many disciples, including the Four Horsemen—the new New Atheists Richard Dawkins, Dan Dennett, Christopher Hitchens and Sam Harris. Probably nowhere are the pseudoscientific half-truths they peddle more amply revealed than in this lecture by Richard Dawkins (beginning at minute 40:00):

    For a long time, certainly during all of Rand’s lifetime, the New Atheists, without a doubt due to their deep-pocked patrons and sponsors, ran roughshod over the academic community. Anyone foolish enough to assert “man’s capacity to do good” was exiled into academic oblivion. However, with more recent findings by neuroscientists, the “red in tooth and claw” portrayal of man proselytized by the New Scientists has become empirically indefensible.

    So what can be seen in Dawkins’ presentation is his acknowledgment that man does indeed have the capacity to do good, but with the qualification that this is a “mistake” or “misfire.” Man ought to follow his instincts for greed and selfishness, Dawkins advises us, because these benevolent impulses no longer function to enhance survival.

    On the religious front, the perversion and corruption is just as egregious. We find the mirror image of Dawkins, Dennett, Harris and Hitchens in such well-known Christian evangelical figures as Pat Robertson, Jerry Falwell, James Dobson, Jim Bakker, Tim LaHaye, James Robinson and a host of other millionaire preachers. Other denominations notable for smiling kindly upon greed and selfishness are the Mormons and the Missouri Synod Lutherans. Kevin Phillips, Andrew J. Bacevich and Greg Grandin, between the three of them do a superb job of researching the current state of right-wing religion in America and its celebration of greed and selfishness.

    In the arts, we see the “greed is good” message not only overtly verbalized by the artist, but also conveyed in the iconic sharks and gold-plated bulls of the billionaire-artist Damien Hirst.

    And I suppose this audience needs no schooling on how, as Amitai Etzioni so thoroughly documented in The Moral Dimension, “neoclassicists have labored long and hard to show that practically all behavior is driven by pleasure and self-interest.” “The neoclassical paradigm does not merely ignore the moral dimension but actively opposes its inclusion,” he writes.

    And politics? What can we say about politics?

    Francois Haas in “German science and black racism—roots of the Nazi Holocaust” posits a rather interesting theory. Traditional political theory, Haas explains, holds that “science under dictatorship becomes subordinated to the guiding philosophy of the dictatorship.” Haas, however, says: “I am proposing the inverse, that Politics under Science becomes subordinated to the guiding philosophy of that Science.”

    So as the little piece of ground that the New Atheists stand upon is eroded away, as the tyranny they inflicted upon the academe is swept away, does that not give hope that the evil politics they inspired will also be swept away?

  8. Vinny G.

    I will have to catch this Frontline piece online. But I am 100% sure their hindsight is 100% accurate…

    Vinny G.

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