The Reckoning: Deregulator Looks Back, Unswayed
By ERIC LIPTON and STEPHEN LABATON | November 17, 2008
WASHINGTON — Back in 1950 in Columbus, Ga., a young nurse working double shifts to support her three children and disabled husband managed to buy a modest bungalow on a street called Dogwood Avenue.
Phil Gramm, the former United States senator, often told that story of how his mother acquired his childhood home. Considered something of a risk, she took out a mortgage with relatively high interest rates that he likened to today’s subprime loans.
A fierce opponent of government intervention in the marketplace, Mr. Gramm, a Republican from Texas, recalled the episode during a 2001 Senate debate over a measure to curb predatory lending. What some view as exploitive, he argued, others see as a gift.
“Some people look at subprime lending and see evil. I look at subprime lending and I see the American dream in action,” he said. “My mother lived it as a result of a finance company making a mortgage loan that a bank would not make.”
On Capitol Hill, Mr. Gramm became the most effective proponent of deregulation in a generation, by dint of his expertise (a Ph.D in economics), free-market ideology, perch on the Senate banking committee and force of personality (a writer in Texas once called him “a snapping turtle”). And in one remarkable stretch from 1999 to 2001, he pushed laws and promoted policies that he says unshackled businesses from needless restraints but his critics charge significantly contributed to the financial crisis that has rattled the nation.
He led the effort to block measures curtailing deceptive or predatory lending, which was just beginning to result in a jump in home foreclosures that would undermine the financial markets. He advanced legislation that fractured oversight of Wall Street while knocking down Depression-era barriers that restricted the rise and reach of financial conglomerates.
And he pushed through a provision that ensured virtually no regulation of the complex financial instruments known as derivatives, including credit swaps, contracts that would encourage risky investment practices at Wall Street’s most venerable institutions and spread the risks, like a virus, around the world.
Many of his deregulation efforts were backed by the Clinton administration. Other members of Congress — who collectively received hundreds of millions of dollars in campaign contributions from financial industry donors over the last decade — also played roles.
Many lawmakers, for example, insisted that Fannie Mae and Freddie Mac, the nation’s largest mortgage finance companies, take on riskier mortgages in an effort to aid poor families. Several Republicans resisted efforts to address lending abuses. And Congressional committees failed to address early symptoms of the coming illness.
But, until he left Capitol Hill in 2002 to work as an investment banker and lobbyist for UBS, a Swiss bank that has been hard hit by the market downturn, it was Mr. Gramm who most effectively took up the fight against more government intervention in the markets.
“Phil Gramm was the great spokesman and leader of the view that market forces should drive the economy without regulation,” said James D. Cox, a corporate law scholar at Duke University. “The movement he helped to lead contributed mightily to our problems.”
In two recent interviews, Mr. Gramm described the current turmoil as “an incredible trauma,” but said he was proud of his record.
He blamed others for the crisis: Democrats who dropped barriers to borrowing in order to promote homeownership; what he once termed “predatory borrowers” who took out mortgages they could not afford; banks that took on too much risk; and large financial institutions that did not set aside enough capital to cover their bad bets.
But looser regulation played virtually no role, he argued, saying that is simply an emerging myth.
“There is this idea afloat that if you had more regulation you would have fewer mistakes,” he said. “I don’t see any evidence in our history or anybody else’s to substantiate it.” He added, “The markets have worked better than you might have thought.”
Rejecting Common Wisdom
Mr. Gramm sees himself as a myth buster, and has long argued that economic events are misunderstood.
Before entering politics in the 1970s, he taught at Texas A & M University. He studied the Great Depression, producing research rejecting the conventional wisdom that suicides surged after the market crashed. He examined financial panics of the 19th century, concluding that policy makers and economists had repeatedly misread events to justify burdensome regulation.
“There is always a revisionist history that tries to claim that the system has failed and what we need to do is have government run things,” he said.
From the start of his career in Washington, Mr. Gramm aggressively promoted his conservative ideology and free-market beliefs. (He was so insistent about having his way that one House speaker joked that if Mr. Gramm had been around when Moses brought the Ten Commandments down from Mount Sinai, the Texan would have substituted his own.)
He could be impolitic. Over the years, he has urged that food stamps be cut because “all our poor people are fat,” said it was hard for him “to feel sorry” for Social Security recipients and, as the economy soured last summer, called America “a nation of whiners.”
His economic views — and seat on the Senate banking committee — quickly won him support from the nation’s major financial institutions. From 1989 to 2002, federal records show, he was the top recipient of campaign contributions from commercial banks and in the top five for donations from Wall Street. He and his staff often appeared at industry-sponsored speaking events around the country.
From 1999 to 2001, Congress first considered steps to curb predatory loans — those that typically had high fees, significant prepayment penalties and ballooning monthly payments and were often issued to low-income borrowers. Foreclosures on such loans were on the rise, setting off a wave of personal bankruptcies.
But Mr. Gramm did everything he could to block the measures. In 2000, he refused to have his banking committee consider the proposals, an intervention hailed by the National Association of Mortgage Brokers as a “huge, huge step for us.”
A year later, he objected again when Democrats tried to stop lenders from being able to pursue claims in bankruptcy court against borrowers who had defaulted on predatory loans.
While acknowledging some abuses, Mr. Gramm argued that the measure would drive thousands of reputable lenders out of the housing market. And he told fellow senators the story of his mother and her mortgage.
“What incredible exploitation,” he said sarcastically. “As a result of that loan, at a 50 percent premium, so far as I am aware, she was the first person in her family, from Adam and Eve, ever to own her own home.”
Once again, he succeeded in putting off consideration of lending restrictions. His opposition infuriated consumer advocates. “He wouldn’t listen to reason,” said Margot Saunders of the National Consumer Law Center. “He would not allow himself to be persuaded that the free market would not be working.”
Speaking at a bankers’ conference that month, Mr. Gramm said the problem of predatory loans was not of the banks’ making. Instead, he faulted “predatory borrowers.” The American Banker, a trade publication, later reported that he was greeted “like a conquering hero.”
At the Altar of Wall Street
Mr. Gramm would sometimes speak with reverence about the nation’s financial markets, the trading and deal making that churn out wealth.
“When I am on Wall Street and I realize that that’s the very nerve center of American capitalism and I realize what capitalism has done for the working people of America, to me that’s a holy place,” he said at an April 2000 Senate hearing after a visit to New York.
That viewpoint — and concerns that Wall Street’s dominance was threatened by global competition and outdated regulations — shaped his agenda.
In late 1999, Mr. Gramm played a central role in what would be the most significant financial services legislation since the Depression. The Gramm-Leach-Bliley Act, as the measure was called, removed barriers between commercial and investment banks that had been instituted to reduce the risk of economic catastrophes. Long sought by the industry, the law would let commercial banks, securities firms and insurers become financial supermarkets offering an array of services.
The measure, which Mr. Gramm helped write and move through the Senate, also split up oversight of conglomerates among government agencies. The Securities and Exchange Commission, for example, would oversee the brokerage arm of a company. Bank regulators would supervise its banking operation. State insurance commissioners would examine the insurance business. But no single agency would have authority over the entire company.
“There was no attention given to how these regulators would interact with one another,” said Professor Cox of Duke. “Nobody was looking at the holes of the regulatory structure.”
The arrangement was a compromise required to get the law adopted. When the law was signed in November 1999, he proudly declared it “a deregulatory bill,” and added, “We have learned government is not the answer.”
In the final days of the Clinton administration a year later, Mr. Gramm celebrated another triumph. Determined to close the door on any future regulation of the emerging market of derivatives and swaps, he helped pushed through legislation that accomplished that goal.
Created to help companies and investors limit risk, swaps are contracts that typically work like a form of insurance. A bank concerned about rises in interest rates, for instance, can buy a derivatives instrument that would protect it from rate swings. Credit-default swaps, one type of derivative, could protect the holder of a mortgage security against a possible default.
Earlier laws had left the regulation issue sufficiently ambiguous, worrying Wall Street, the Clinton administration and lawmakers of both parties, who argued that too many restrictions would hurt financial activity and spur traders to take their business overseas. And while the Commodity Futures Trading Commission — under the leadership of Mr. Gramm’s wife, Wendy — had approved rules in 1989 and 1993 exempting some swaps and derivatives from regulation, there was still concern that step was not enough.
After Mrs. Gramm left the commission in 1993, several lawmakers proposed regulating derivatives. By spreading risks, they and other critics believed, such contracts made the system prone to cascading failures. Their proposals, though, went nowhere.
But late in the Clinton administration, Brooksley E. Born, who took over the agency Mrs. Gramm once led, raised the issue anew. Her suggestion for government regulations alarmed the markets and drew fierce opposition.
In November 1999, senior Clinton administration officials, including Treasury Secretary Lawrence H. Summers, joined by the Federal Reserve chairman, Alan Greenspan, and Arthur Levitt Jr., the head of the Securities and Exchange Commission, issued a report that instead recommended legislation exempting many kinds of derivatives from federal oversight.
Mr. Gramm helped lead the charge in Congress. Demanding even more freedom from regulators than the financial industry had sought, he persuaded colleagues and negotiated with senior administration officials, pushing so hard that he nearly scuttled the deal. “When I get in the red zone, I like to score,” Mr. Gramm told reporters at the time.
Finally, he had extracted enough. In December 2000, the Commodity Futures Modernization Act was passed as part of a larger bill by unanimous consent after Mr. Gramm dominated the Senate debate.
“This legislation is important to every American investor,” he said at the time. “It will keep our markets modern, efficient and innovative, and it guarantees that the United States will maintain its global dominance of financial markets.”
But some critics worried that the lack of oversight would allow abuses that could threaten the economy.
Frank Partnoy, a law professor at the University of San Diego and an expert on derivatives, said, “No one, including regulators, could get an accurate picture of this market. The consequences of that is that it left us in the dark for the last eight years.” And, he added, “Bad things happen when it’s dark.”
In 2002, Mr. Gramm left Congress, joining UBS as a senior investment banker and head of the company’s lobbying operation.
But he would not be abandoning Washington.
Lobbying From the Outside
Soon, he was helping persuade lawmakers to block Congressional Democrats’ efforts to combat predatory lending. He arranged meetings with executives and top Washington officials. He turned over his $1 million political action committee to a former aide to make donations to like-minded lawmakers.
Mr. Gramm, now 66, who declined to discuss his compensation at UBS, picked an opportune moment to move to Wall Street. Major financial institutions, including UBS, were growing, partly as a result of the Gramm-Leach-Bliley Act.
Increasingly, institutions were trading the derivatives instruments that Mr. Gramm had helped escape the scrutiny of regulators. UBS was collecting hundreds of millions of dollars from credit-default swaps. (Mr. Gramm said he was not involved in that activity at the bank.) In 2001, a year after passage of the commodities law, the derivatives market insured about $900 billion worth of credit; by last year, the number hadswelled to $62 trillion.
But as housing prices began to fall last year, foreclosure rates began to rise, particularly in regions where there had been heavy use of subprime loans. That set off a calamitous chain of events. The weak housing markets would create strains that eventually would have financial institutions around the world on the edge of collapse.
UBS was among them. The bank has declared nearly $50 billion in credit losses and write-downs since the start of last year, prompting a bailout of up to $60 billion by the Swiss government.
As Mr. Gramm’s record in Congress has come under attack amid all the turmoil, some former colleagues have come to his defense.
“He is a true dyed-in-the-wool free-market guy. He is very much a purist, an idealist, as he has a set of principles and he has never abandoned them,” said Peter G. Fitzgerald, a Republican and former senator from Illinois. “This notion of blaming the economic collapse on Phil Gramm is absurd to me.”
But Michael D. Donovan, a former S.E.C. lawyer, faulted Mr. Gramm for his insistence on deregulating the derivatives market.
“He was the architect, advocate and the most knowledgeable person in Congress on these topics,” Mr. Donovan said. “To me, Phil Gramm is the single most important reason for the current financial crisis.”
Mr. Gramm, ever the economics professor, disputes his critics’ analysis of the causes of the upheaval. He asserts that swaps, by enabling companies to insure themselves against defaults, have diminished, not increased, the effects of the declining housing markets.
“This is part of this myth of deregulation,” he said in the interview. “By and large, credit-default swaps have distributed the risks. They didn’t create it. The only reason people have focused on them is that some politicians don’t know a credit-default swap from a turnip.”
But many experts disagree, including some of Mr. Gramm’s former allies in Congress. They say the lack of oversight left the system vulnerable.
“The virtually unregulated over-the-counter market in credit-default swaps has played a significant role in the credit crisis, including the now $167 billion taxpayer rescue of A.I.G.,” Christopher Cox, the chairman of the S.E.C. and a former congressman, said Friday.
Mr. Gramm says that, given what has happened, there are modest regulatory changes he would favor, including requiring issuers of credit-default swaps to demonstrate that they have enough capital to back up their pledges. But his belief that government should intervene only minimally in markets is unshaken.
“They are saying there was 15 years of massive deregulation and that’s what caused the problem,” Mr. Gramm said of his critics. “I just don’t see any evidence of it.”
Griff Palmer contributed reporting from New York.