PHIL GRAMM: THERE’S MORE…

Recently, two more articles about Phil Gramm, “McCain’s Economic Brain“, have appeared. MSNBC had reported a week ago that Gramm was a paid lobbyist for UBS, one of the banks most heavily involved in the subprime scandal, until six weeks ago. Now Newsweek adds this:

“NEWSWEEK has learned that UBS is also currently the focus of congressional and Justice Department investigations into schemes that allegedly enabled wealthy Americans to evade income taxes by stashing their money in overseas havens, according to several law-enforcement and banking officials in both the United States and Europe, who all asked for anonymity when discussing ongoing investigations. In April, UBS withdrew Gramm’s lobbying registration, but one of his former congressional aides, John Savercool, is still registered to lobby legislators for UBS on numerous issues, including a bill cosponsored by Sen. Barack Obama that would crack down on foreign tax havens. “UBS is treating these investigations with the utmost seriousness and has committed substantial resources to cooperate,” a UBS spokesman told NEWSWEEK, adding that Gramm was deregistered as a lobbyist because he spends less than 20 percent of his time on such activity. Hazelbaker said the McCain campaign “will not comment on the details … of ongoing investigations and legal charges not yet proved in court.””

A new article in the Texas Observer is even more interesting, and worth reading in its entirety. It begins:

“In the early evening of Friday, December 15, 2000, with Christmas break only hours away, the U.S. Senate rushed to pass an essential, 11,000-page government reauthorization bill. In what one legal textbook would later call “a stunning departure from normal legislative practice,” the Senate tacked on a complex, 262-page amendment at the urging of Texas Sen. Phil Gramm.

There was little debate on the floor. According to the Congressional Record, Gramm promised that the amendment — also known as the Commodity Futures Modernization Act –along with other landmark legislation he had authored, would usher in a new era for the U.S. financial services industry.(…)

With the U.S. economy now battered by a tsunami of mortgage foreclosures, the $30-billion Bear Stearns Companies bailout and spiking food and energy prices, many congressional leaders and Wall Street analysts are questioning the wisdom of the radical deregulation launched by Gramm’s legislative package. Financial wizard Warren Buffett has labeled the risky new investment instruments Gramm unleashed “financial weapons of mass destruction.” They have fed the subprime mortgage crisis like an accelerant. While his distracted peers probably finalized their Christmas gift lists, Gramm created what Wall Street analysts now refer to as the “shadow banking system,” an industry that operates outside any government oversight, but, as witnessed by the Bear Stearns debacle, requiring rescue by taxpayers to avert a national economic catastrophe.”

One part of that bill was what’s called the ‘Enron Loophole’:

“The impact of the “Enron loophole” has been enormous. Since its passage, the Senate Permanent Subcommittee on Investigations has concluded that the loophole contributed to inflated energy prices for American consumers. In 2006, its report found credible expert estimates that the loophole — by encouraging speculation — accounted for $20 of the price of a barrel of oil, then at $70. In 2007, the same committee blamed the loophole for price manipulation of the natural gas market by a single hedge fund, Amaranth Advisors.”

But Gramm’s legislation also seems to have legalized what are known as ‘credit default swaps’:

“Prior to its passage, they say, banks underwrote mortgages and were responsible for the risks involved. Now, through the use of credit default swaps — which in theory insure the banks against bad debts — those risks are passed along to insurance companies and other investors.

Maryland law professor Greenberger believes credit default swaps “were a key factor in encouraging lenders to feel they could make loans without knowing the risks or whether the loan would be paid back. The Commodity Futures Modernization Act freed them of federal oversight.”

Before passage of the modernization act, the Commodity Futures Trading Commission was attempting to regulate the swaps market through rule-making. The modernization act, Gramm noted in his remarks on the Senate floor, provided “legal certainty” for the growing swaps market. That was necessary, Greenberger says, because at the time, “banks were doing these trades in direct violation of federal law.””

There’s a decent explanation of credit default swaps here. As I understand it, the basic idea is this:

Suppose I have a risky loan, and I want to insure against losses. I agree with someone else — call him or her X — that she will pay back my loan if the person I made it to defaults. In exchange for this insurance policy, I will pay her — maybe I’ll send her the loan payments, suitably adjusted for risk. In any case, X gets cash, and I (supposedly) get peace of mind.

In a normal, regulated insurance market, there would be requirements that (for instance) X have enough capital to make good if my loan defaults. X would also not be able to sell the contract to make good my losses to just anyone, and X would certainly have to tell me about any such sale. But in the world of CDSs, neither requirement exists. CDS contracts can be sold and resold, and I might have no idea who is actually supposed to repay me if my loan goes into default. Moreover, there are no capital requirements on some of the people who can buy them. So if a lot of CDSs require payment from X all at once, there’s no guarantee that X will be able to pay up. As the NYT puts it:

“It would be as if homeowners, facing losses after a hurricane, could not identify the insurance companies to pay on their claims. Or, if they could, they discovered that their insurer had transferred the policy to another company that could not cover the claim.”

But it gets worse: in a lot of cases, X is a hedge fund. Hedge funds are highly leveraged, and therefore a relatively small downturn in their underlying assets (like some of their CDSs needing to be paid up) can wipe them out. Moreover, the alternative to a CDS, normally, would be to buy the underlying risky asset. CDSs allow people to assume the risks and benefits of owning that asset without actually putting money down. Instead, they get money: a cash stream, which they can then use to make more highly leveraged bets.

This is just a recipe for instability: for allowing unregulated financial institutions to place themselves, and the rest of the financial universe, at risk through unregulated, highly leveraged, and deeply risky maneuvers. And the CDS market is huge:

“The CDS market exploded over the past decade to more than $45 trillion in mid-2007, according to the International Swaps and Derivatives Association. This is roughly twice the size of the U.S. stock market (which is valued at about $22 trillion and falling) and far exceeds the $7.1 trillion mortgage market and $4.4 trillion U.S. treasuries market, notes Harvey Miller, senior partner at Weil, Gotshal & Manges. “It could be another — I hate to use the expression — nail in the coffin,” said Miller, when referring to how this troubled CDS market could impact the country’s credit crisis.”

If Gramm basically legalized credit default swaps, then his involvement in the subprime crisis goes far beyond his work for UBS. And John McCain should have to explain why he thinks that Phil Gramm is a good person to turn to for economic advice.

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