Does anyone in the current administration even remember Enron? Judging by President Bush’s two nominees to the Commodity Futures Trading Commission (CFTC), who appeared at Senate hearings on Tuesday, the answer is no.
If there was one thing that could legitimately be hoped for after the biggest corporate bankruptcy of all time, it was that accounting rules would be tightened, and the rush to dismantle regulatory oversight over the kind of complicated financial games that Enron specialized in would be reversed. But instead, the people most responsible for loosening the rules are being put in charge.
The CFTC is the government agency that is supposed to be the watchdog over such advanced “financial instruments” as derivatives trading. But Bush’s nominees boast what critics call a laughable regulatory record. Walter Lukken is the drafter of a law passed in 2000 that gave Enron’s online trading arm the right to act without a shred of oversight. Sharon Brown-Hruska is a free-market economist and protigi of Wendy Gramm, the former CFTC commissioner who, after shepherding through a regulatory exemption for Enron, resigned from the commission and joined the company’s board of directors.
Enron’s implosion last fall and winter was declared at the time to be a watershed event, a Teapot Dome-like scandal that would lead to new legislation, increased oversight and greater degrees of financial transparency. Enron, the argument went, would be the spark that set ablaze a fire of reform.
If anything, the wave of corporate accounting scandals that dominated the business headlines all spring might have been expected to give even more fuel to the forces of reform. On June 23, Treasury Secretary Paul O’Neill declared that he and the Bush administration were “outraged” at the current rash of corporate malfeasance.
But little has actually changed, and the backgrounds of the new nominees to the CFTC — along with Congress’ rejection, earlier this spring, of a bill aiming to give the CFTC more responsibility for regulating energy traders — put the lie to O’Neill’s rhetoric. More than six months after Enron declared bankruptcy, the regulatory landscape is largely the same as it was before Enron’s problems became public. In fact, says Michael Greenberger, a law professor at the University of Maryland and the former director of trading and markets at the CFTC, “It’s not changed at all.”
“The mantra for not regulating is that these are isolated events,” says Greenberger. “But when you look across the spectrum, how can it be an isolated event with Enron, with Tyco, Arthur Andersen, Global Crossing, Adelphia, ImClone and all the others? What’s needed is a very dramatic reversal, almost to the kind Bush made with the Office of Homeland Security. And except for an accounting measure getting out of the Senate banking committee [which would create an independent board to oversee the industry], everything strong has failed.”
Enron proved, among other things, that lobbying and large donations are an excellent way to rewrite the corporate rulebook. The list of the company’s political victories is long and diverse. Electricity deregulation, the power to essentially veto appointments at the Federal Energy Regulatory Commission, passage of a law that exempted EnronOnline from all oversight — these are just a few of the perks that Enron claimed on its way up the Fortune 500 ladder.
But perhaps no single instance demonstrates Enron’s success better than its influence over the CFTC. The commission could have and should have been Enron’s key regulator. The CFTC is the agency most closely aligned what turned out to be one of Enron’s primary profit centers: derivatives trading.
The term “derivatives” is used to describe a class of financial contracts that are derived from another asset and priced according to that asset’s value. Also known as a form of “risk management,” over the past 20 years derivatives trading has become increasingly popular on Wall Street as a way to “hedge” risk, to protect yourself from an investment bet that goes sour or from swings in interest rates or currency prices. Enron, although once primarily a trader in actual physical commodities such as gas and electricity, rapidly developed in the late ’90s into a serious trader of derivatives based on a vast array of commodities.
The question of how to regulate derivatives has been at the heart of a vigorous, if abstruse, debate for the past 20 years between Wall Street and Washington. Enron has been in the middle of the battle, and until its demise, won every skirmish.
The first victory came in 1993. At that time, Enron’s primary business was selling actual energy but the Houston company wanted to get involved in selling energy derivatives. But rather than put up with the oversight requirements of the CFTC, Enron lobbied for an exemption — the right to trade energy derivatives without being subject to CFTC jurisdiction.
Wendy Gramm, chairwoman of the CFTC from February 1988 to January 1993, agreed. She shepherded the exemption through, and in April of 1993 — after Gramm quit the CFTC and took a seat on Enron’s board of directors — the CFTC approved the policy Enron favored.
Enron took its exemption to the bank. Its derivatives business grew enormously over the next few years. Eventually, however, the exemption came up once again for debate. By the end of 1997, derivatives contracts of all kinds represented more than $25 trillion in real assets, and many in Congress — and at the CFTC — wanted to know more about their effects. Brooksley Born, a Clinton appointee who became the head of the CFTC in 1996, called for oversight.
“In late 1997 and early 1998, she said the emperor has no clothes,” says Greenberger. “She said that derivatives are futures contracts and that the CFTC had jurisdiction.”
But once again, Enron carried the day. A handful of legislators, including Sen. Phil Gramm, R-Texas (husband of Wendy Gramm), defeated the forces of regulation, with no small help from the U.S. Treasury Department, the Federal Reserve and the Securities and Exchange Commission. All three government agencies, though headed by Born’s fellow Clinton appointees, scorned her new CFTC proposal. They even issued a rare joint statement declaring, “We have grave concerns about this action and its possible consequences. We seriously question the scope of the CFTC’s jurisdiction in this area.”
After a report favoring less regulation rather than more reached both houses, Congress acted. In December 2000, the Commodities Futures Modernization Act (CFMA) became law. The CFMA essentially established derivatives as a new, unregulated form of finance.
“The CFMA made it clear that this kind of trading would be exempted,” Greenberger says. “Only a handful of congressmen and senators probably realized that they were enacting this deregulatory provision.”
For those working under the law, however, the CFMA has proven hard to ignore. Thomas Erickson, a Clinton-appointed commissioner, says that the law has severely undermined the agency’s ability to keep track of the economy. Not only does the law let companies deal in derivatives without maintaining established levels of capital (to protect against overextended investing), as banks are required to do; the law also protects companies from having to disclose information about their derivatives business.
“It’s a black hole of information,” says Erickson. “It’s off our radar completely.”
Ultimately, he adds, the law makes it much harder for the CFTC to do its job — to hold companies accountable.
“It’s a real challenge,” Erickson says. “We’ve got so many built-in hurdles to an investigation that you have the possibility of having your jurisdiction questioned at every stage. Where we are today, I believe that we would be hard pressed to be able to reach the same kinds of settlements as we did before the CFMA, like with Sumitomo, a case where the commission earned a $150 million settlement for the manipulation of copper prices.”
Immediately after Enron’s bankruptcy, Sen. Dianne Feinstein, D-Calif., drafted legislation that aimed to close the loophole in the CFMA that allows energy trading to be exempt from regulatory oversight. The law would have put electronic energy exchanges like Enron’s EnronOnline under CFTC jurisdiction: Companies would have to disclose information on trading volumes, players, profits and losses while also keeping capital reserves.
There is no guarantee that CFTC oversight could have prevented Enron’s collapse. But experts argue that it would have made Enron’s troubles more visible. Regulators have learned only recently that Enron controlled about 25 percent of all U.S. wholesale energy trades during its peak, and that during the California energy crisis, the company — according to its own internal documents — used its market power to manipulate the market. Feinstein maintains that her proposal, which would have put energy and metal trades under CFTC jurisdiction, would prevent a similar scenario from occurring elsewhere.
“In terms of energy derivatives, there seems to have been real gaming of the market, so it’s clear that there needs to be some basic oversight,” says Howard Gantman, a Feinstein spokesman. “It existed in the past — until the CFMA — and we’d like it to be returned.”
But in order to achieve this goal, Feinstein has been forced to go up against many of the same forces that kept the CFTC impotent for much of the ’90s. So far, she’s lost. Her attempt to tie the legislation to the Senate energy bill failed in April by two votes.
“At present, there is no constituency for reform in the derivatives world, and there won’t be until a major financial institution collapses — which will happen,” says Mayer, author of “The Fed” and more than a dozen other finance books. “Until then, the Fed, the SEC, the CFTC, the Treasury, Congress and the White House will all accept the industry’s lunatic claim that the tightening of links between markets, the elimination of friction and the loss of redundancy improves the reported profits of derivatives transactions and stabilizes the system.”
Bush’s nominations to the CFTC add insult to injury for critics looking for real reform.
Brown-Hruska started her career as an economist whose Ph.D. thesis argued that markets self-correct against price manipulation — no regulation or disclosure required. In 2001 she co-wrote an article for Barron’s that argued against an SEC proposal that would force brokers to reveal how much they paid for exclusive market information.
She also served as chief economist at the CFTC from 1990 to 1995 under then-chairwoman Wendy Gramm. She now works as an assistant professor of finance at George Mason University’s Mercatus Center — a free-market think tank headed by Gramm, and which has received $50,000 from Enron since 1996.
Given the degree of outrage over Enron, says Greenberger, “the idea that a protigi of Wendy Gramm could be placed on the commission that will investigate this issue is mind boggling.”
Lukken’s record is similarly tainted. A former legislative assistant to Sen. Richard Lugar, R-Ind., Lukken has one major piece of legislation associated with him: the CFMA, a law which current CFTC commissioner Erickson describes as “Swiss cheese,” meaning “there are so many holes that let you get out of the block.”
“[Lukken and Brown-Hruska] don’t represent any new thinking that will provide a remedy,” says Randall Dodd, director of the Derivatives Study Center. “What needs to be done is broad rethinking of where the system has failed, and how to come up with new solutions. These people have never supported a government regulation in their life. And at this juncture, that’s not the type of narrow-minded thinking that’s needed.”
Brown-Hruska declined to comment on her appropriateness for appointment to the CFTC.
Seth Boffelli, a spokesman for Sen. Tom Harkin, D-Iowa, who is chairing the hearings on the pair of Bush nominees, said only that “I’m sure there will be some tough questions asked and depending on what they say, we’ll go from there.”
To critics, Bush’s nomination of two people who are the epitome of the deregulatory thinking that allowed Enron to get away with financial murder is a clear indication that no substantive changes can be expected from the current administration. But some potential critics are holding fire.
“I haven’t seen significant change yet, but I think the jury is still out,” says Brooksley Born, now in private practice. “Congress is still working on a number of things, and the administration itself is also in the process of working out some issues. So we have to wait and see.”
But some critics argue that we are waiting and seeing our way into a continued financial meltdown. The signs are obvious, they say: The energy industry has been battered in the stock market; the NASDAQ is at lows not seen since Sept. 11.
“There’s a crisis of confidence in the market, in energy in particular,” says Erickson. “The participants no longer trust each other or have confidence in each other. I’m as interested as anyone else in seeing the markets grow and I think there are a few simple things that you can attach that instill confidence — transparency, disclosure requirements. Those are the kinds of things that are the cornerstones of markets.”
Robert Shiller, author of “Irrational Exuberance,” agrees. “In the long run, business people are better off if we have good strong regulations in place to prevent shenanigans from happening,” he says. “If people are getting upset, we need to take measures that have some teeth. The mood is souring; we need to do something.”