In 2005, when Timothy Geithner was head of the New York Fed, he ignored one of the greatest dangers our financial markets have ever faced. And that danger was buried deep inside our banks, in the unregulated market of Credit Default Swaps (CDS).
If you buy a stock from another party, the trade is forced to settle by the exchange within three days. This prevents any gray areas of ownership, which is critical for tracking the amount of risk in the financial system. Even if you bought a stock and immediately sold it to someone who then flogged it to another buyer, all these trades must be settled in the exchanges. This is the proper, regulated environment of the stock market.
But with CDS, this is not the case. It is like the Wild West, where trades are settled by hand in an over-the-counter market. Can you imagine the paperwork? And when the market exploded in 2005, during a time when traders made astronomical piles of money, the CDS paperwork piled higher and higher, until a pile the size of Mount Everest sat in the back offices of Wall Street.
With months and months of unsettled CDS trades, and with the unstoppable 300 m.p.h. gravy-train steaming forward, Timothy Geithner, our current Secretary of the United States Treasury, just stood there like a bird watcher on the side of tracks, doing absolutely nothing about it.
The "Over-the-Counter Derivatives Markets Act of 2009", which passed the House Financial Services Committee on a party line vote, was cleverly designed with a "trigger" to facilitate a White House takeover of the $54 trillion credit derivatives markets.
The draft legislation warns that if the "SEC and the Commodities Futures Trading Commission cannot jointly prescribe uniform rules and regulations under any provision of this act in a timely manner [60 days], the Secretary of the Treasury...shall prescribe rules and regulations under such provision."
Considering the relationship between the SEC and CFTC has been defined by decades of territorial feuding, Secretary Geithner will quickly usurp oversight of this critical market.
But Mr. Geithner's dubious regulatory record as President of the Federal Reserve Bank of New York from 2003 to 2008, makes him a curious candidate to become "Master of the Derivative's Universe."
When spectacular problems in the Credit Default Swaps (CDS) markets came to his attention following the bankruptcies of Delta and Northwest Airlines in 2005, he allowed the industry to continue to self-regulate its trading activities.
Every day billions of dollars of CDS contracts had been trading between banks, brokers and hedge funds, but contract execution to settle these transactions was often delayed by months. Literally hundreds of billions of dollars of outstanding derivative contract risk was floating off the balance sheets of the major financial institutions. This strategy allowed the derivative traders to engage in the equivalent of "check kiting" on a grand scale.
The turmoil in the markets and the size of 2005 losses made clear to the New York Fed that many banks were engaged in activities that skirted prudent banking standards. As head of trading for the world's largest bank, Mr. Geithner could have used his authority to force the derivative industry to comply with settling all trades in three days. Instead of acting decisively to eliminate a known and growing systemic threat, he watched financial cancer quietly metastasize.
In an October 4, 2005 letter to Mr. Geithner, the 'Major Dealers' committed to reducing the number of confirmations outstanding longer than 30 days, by 30% over the next five months. The letter, signed by Bank of America, Barclays Capital, Bear Stearns, Citigroup, Credit Suisse, Deutsche Bank, Goldman Sachs, HSBC, JP Morgan Chase, Lehman Brothers, Merrill Lynch, Morgan Stanley, UBS and Wachovia states unequivocally that anything less than "significant progress on our backlogs...will be unacceptable."
Over the next two and a half years, the Major Dealers spoke regularly with the New York Fed regarding the "tactical" steps they were taking to reduce the enormous number of outstanding trades. In a March 27, 2006 letter to Geithner, the Major Dealers agreed to provide only "informal updates" on their efforts to implement industry wide processing guidelines by the end of the year.
This was a critical moment in the history of the financial markets. It marked the day when the New York Fed and the US Treasury went to bed with Wall St. The grass had become too high to cut, and now they were married to this deadly mountain of unsettled CDS risk. But if Geithner had taken prudent action in 2005, forced Wall Street to settle the trades within seven days, the financial crisis might have been averted.
At a time when dangerous activities in the Credit Derivatives market demanded legal scrutiny and public disclosure, Geithner permitted the industry to avoid unpleasant intrusions into their most profitable business practices. Given confirmations should have been sent in one day, and signed contracts and collateral transferred in a maximum of three days. It is now clear the New York Fed was willing to allow the industry to self police their way back into compliance.
It took one of the Major Dealers going bankrupt to spur the necessary change. Two weeks after the collapse of Bear Stearns, in a letter dated March 27, 2008 the "Major Dealers" finally agreed to begin clearing trades electronically. By then, billions of taxpayer dollars had been put at risk, and the market was in a death spiral.
When Lehman Brothers failed on September 15, 2008, credit froze at banks around the word for the main reason that banks couldn't determine who was exposed to Lehman. The settlement of Credit Default Swaps, an-over-the-counter market, did not keep up with the volume of trading. Our Fed and Treasury were flying blind when they let Lehman fail. And we'll be paying the price for many years.
The mantra of the Administration has been "you never want a serious crisis to go to waste." However, before handing the keys of the regulatory kingdom back to the deceptive Mr. Geithner, the public deserves to know about his three years of total incompetence, and they need to hear about the billowing risk in the credit derivatives markets, and how he failed to protect our nation.
By Chriss W. Street, Orange Country Treasurer
and Lawrence G. McDonald, author of "A Colossal Failure of Common Sense," and international financial lecturer.
Follow Lawrence G. McDonald on Twitter: www.twitter.com/convertbond