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The Untold Story: Brooksley Born, Larry Summers & the Truth About Unlimited Risk Potential

Friday, October 05, 2012

Larry Summers is attempting to re-write history at the expense of Brooksley Born, according to some, as fundamental principles of leverage & derivatives management are woefully ignored.

Brooksley Born, Larry Summers, Leverage Design Flaws that Persist Today & Unlimited Risk Potential

By Mark Melin

(This piece contains opinions, which are solely those of the author unless otherwise noted.)

As the western world wakes to the fact it is in the middle of a debt crisis spiral, intelligent voices are wondering how this manifested itself? As we speak, those close to the situation could be engaging in historical revisionism to obfuscate their role in the design of faulty leverage structures that were identified in the derivatives markets in 1998 and 2008.  These same design flaws, first identified in 1998, are persistent today and could become graphically evident in the very near future under the weight of a European debt crisis.

Author and Bloomberg columnist William Cohan chronicles the fascinating start of this historic leverage implosion in his recent article Rethinking Robert Rubin. Readers may recall it was Mr. Cohan who, in 2004, noted leverage issues that ultimately imploded in 2007-08.

At some point, market watchers will realize the debt crisis story will literally change the world. They will look to the root cause of the problem, and they might just find one critical point revealed in Mr. Cohan's article.

This point occurs in 1998 when then Commodity Futures Trading Commission (CFTC) Chairwoman Brooksley Born identified what now might be recognized as core design flaws in leverage structure used in Over the Counter (OTC) transactions. Ms. Born brought her concerns public, by first asking just to study the issue, as appropriate action was not being taken. She issued a concept release paper that simply asked for more information. "The Commission is not entering into this process with preconceived results in mind," the document reads.

Ms. Born later noted in, the PBS Frontline documentary on the topic speculation at the CFTC was the unregulated OTC derivatives were opaque, the risk to the global economy could not be determined and the risk was potentially catastrophic. As a result of this inquiry, Ms. Born was ultimately forced from office.

This brings us to Lawrence Summers, the former Treasury Secretary of the United States and at the time right hand man to then Treasury Security Robert Rubin. Mr. Summers was widely credited with implementation of the aggressive tactics used to remove Ms. Born from her office, tactics that multiple sources describe as showing an old world bias against women piercing the glass ceiling.

According to numerous published reports, Mr. Summers was involved in. silencing those who questioned the opaque derivative product's design. While Mr. Summers should not be solely blamed for the collapse of the OTC derivative products in Europe or elsewhere, should this occur, the lack of understanding of fundamental leverage design structure should be noted.

Structural Leverage Design Flaws Are Commodity Industry Fundamentals

It is important to understand the issue from the perspective from leverage design flaws because it are these core flaws that were root to the 2008 leverage implosion and more importantly are likely to manifest themselves in the next debt crisis if the situation is not identified and properly managed.

Ms. Born had identified several fundamental issues with the design of OTC derivatives: They were opaque, interconnected, involved catastrophic global economic risk which, in total, was unknown risk. These are core fundamental design flaws regardless of the derivative product traded.

What is the Risk? Does a Failure Guarantee Represent Unlimited Risk Potential?

At some point clear thinking economic minds will wake up the catastrophic risk that the Federal Reserve has saddled the US Government. To date, this risk has not been widely exposed. Here is the key concept:

The risk is a derivative contract can be literally limitless.

To illustrate this grave risk this poses, currently neither economic leaders at the Federal Reserve nor Treasury can quantity the risk these derivative products pose to society. The fact that economic leaders cannot even begin to recognize the destructive societal potential these derivative contracts pose illustrates just one of the key structural design flaws that Ms. Born identified. These flaws are particularly a concern if the European "Union" heads down a path to a debt crisis along with the United States. The key is to properly manage the leverage so the implosion does not destroy society, as was done in 1933 Germany, something that managed futures legend Ray Dialo warned in a CNBC interview is one possibility being considered on the risk spectrum by forward thinking economic minds.

It is not only for the serious nature of the leverage design flaws should be exposed, but also attempts to besmirch the reputation of who some consider at true American hero, one of the first females to break the glass ceiling while attempting to expose serious unaddressed issues. Mr. Summers comments in the William Cohen article are not only re-writing history to cover their tracks if the leverage implosion does occur, but they are trying to damage the reputation of a female pioneer whose only offense was pointing out appropriate issues with fundamental leverage issues that will likely impact all.

Was this the First Warning Mr. Summers Ignored?

In addition to time spent fighting Ms. Born over transparency and risk management issues unregulated derivatives, Mr. Summers was also influential in the operation of the Harvard University pension fund. Sources deep in the derivative industry say that Mr. Summers was given a warning about the Collateralized Default Swaps (CDS) in which Harvard had invested. The CDSs were a structurally different product than what Ms Born warned against, but again carried many of the same fundamental derivative design flaws.

Iris Mack, a striking African-American female, was a former derivatives specialist at the Harvard University Management Company. Highly respected in the commodity industry Ms Mack was an Oxford-trained mathematician who joined with thought leaders such as Nassim Taleb and former Goldman Sachs quant Emanuel Derman to write about derivatives.

While at Harvard, sources say Ms Mack gave Mr. Summers a clear warning about the OTC derivatives in which the pension had invested. Ms Mack "became uncomfortable with the lack of understanding she thought her colleagues had with the risky derivatives they were investing in," according to a source. She was proven correct as the fund dropped 27.3 percent that same year - do in large part to the flawed OTC derivative investments. On May 12, 2002, Ms Mack is said to have written the following e-mail to Summers:

As a proud Harvard alum I am deeply troubled and surprised by what I have been exposed to thus far at HMC, and the potential consequences for my alma mater's endowment. In addition, I strongly believe that if my fellow alum[s] knew how the endowment is being managed and the caliber of some of the portfolio managers, they probably would not give another dime to our endowment."

Ms Mack is said to have asked Summers for a meeting and that he keep the correspondence between them confidential, "especially due to the fact that several individuals have been terminated from HMC when they raised concerns about such issues." Nine days later, Mack is said to have received an e-mail from Marne Levine, Summers's chief of staff at Harvard (and now his chief of staff at the National Economic Council), asking Mack to contact her and assuring her that the initial e-mail "remains confidential."  But not for long. A month later, she was said to be confronted by Jack Meyer, then head of H.M.C., who had copies of her correspondence with Summers and Levine. Meyer fired Mack the next day.  She has since reached a confidential settlement with Harvard that she won't discuss. But she is unequivocal about one thing. "I would say that there is 99.99% probability that Summers had a hand in my departure," she is said to have written in an e-mail.

"There is no way Summers had a clue what was going on or what would come (in unregulated derivatives in 2008 and beyond)," said a source close to the situation.  "This is the guy that lost something like 20-30% of the Harvard endowment fund investing in CDOs--the very crap that Born would have been 'regulating.' Iris warned Summers of this and she was summarily fired." Ms Mack could not be reached before deadline on this article.

A pattern is developing.  Those who understand derivatives clearly provide sound warnings, those warnings are again ignored.
 
Problem: Mainstream Doesn't Understand Derivatives, Just Now Waking Up

The mainstream of economic thought is just starting to wake up to the significance Mr. Summers played in laying the foundation of the interconnected leverage issues rising to the surface.  It's a concept Warren Buffet accurately identified when he called these unregulated and opaque OTC derivative contracts "weapons of mass destruction." With government on a mathematical glide path to a debt crisis, the bottom line truth Mr. Summers and his ilk prefer people not understand is that no one currently knows the potential risk in unregulated OTC derivative structures. The potential risk is unlimited and catastrophic, particularly during a debt crisis.

That's the big problem, yet unidentified by mainstream media. Those design flaws that Ms Born identified, and famously blew up in 1998 and 2008, are still present today as the approaching debt crisis threatens to host the most spectacular fireworks show in the history of leverage management.

In 1998 Brooksley Born Exposed Core Design Flaws in Derivative Management That Are Still In Existence Today and Carry Serious Consequences

While it was not commonly described as a "design flaw at the time," then CFTC Chairwoman Brooksley Born essentially identified three fundamental principles of leverage management that were being violated and are still being violated today. This is a new way to look at the issue.  In the commodity industry many are taught fundamental truths of leverage management: transparency, access to total position exposure, always look to avoid catastrophic risk. Ms Born might not have known this, but her documented issues with the OTC derivatives brought up these very issues. ;It is these core fundamentals Mr Summers fought.

Why position it from this perspective? Ms Born lost a battle that desperately needed to be won. Today, as the debt crisis is moving in on Europe, it's only a matter of time before these same fundamental principles Born fought for are at the center of an interconnected OTC implosion. (This same warning was delivered to the Chicago Fed late in September, 2012 along with eight core questions that should be addressed. It is hoped they reviewed this warning.  This might be unlikely, as the track record on the Fed reviewing warnings is a matter of public record.)

To understand the fundamental aspect of the problem,break down Ms Born's stated concerns: record keeping, transparency, no ability to understand the risk potential, which could be catastrophic.  In the regulated commodity industry, these are second nature concerns.  "If something went wrong, the high stakes derivatives market could take down the entire system," according to a PBS/Frontline documentary on the topic. This clear warning is now upon the western world.

What has yet to be fully appreciated is that the same essential leverage design flaws that were violated in 1998, 2008, persist today and have significant potential to implode. This is particularly true during times of crisis, when risk management is needed most - a little known component of the debt crisis that could manifest itself in the future if not properly managed.

  1. Leverage usage in total (sum of all OTC trading) should be transparent. This is the larger issue, the unintended consequence is that without transparency enhanced risk taking typically ensues. But more problematic for practical risk managers is they are unaware of the potential negative consequences and cannot watch as those consequences unfold.
  2. When one is dealing with catastrophic risk, as in the case in the US & EU debt crisis, the design of the leverage structure should not interconnect unrelated multiple parties.  If a debt crisis were to crash upon the economy now, the "insurance" might not have the funds to pay, even after tapping the US Government for a bailout. The problem with a debt crisis, the next bailout could be literally unlimited.
  3. When considering a leveraged derivative, study must take place regarding the potential outcomes both positive and negative, including worst case. While this was never a public concern at the time, the issue of recognizing the systemic risk in the contract structures, an issue Ms. Born addressed, also speaks to analyzing this information into actionable risk management solutions. Mr. Summers and his ilk were most fond of considering the best case questioning, an approach akin to former MF Global president Jon Corzine firing his risk manager when he simply questioned logical, mathematical trajectories.

These were more than hard questions being asked of the OTC design structure. Today, for purposes of tracking their destruction over time, they can be considered core structural design flaws. These highly leveraged structured products have become highly interconnected and carry catastrophic risk for the US economy but nonetheless remain opaque, violate leverage usage principles and hinder any attempt at proper risk management.

Analysis of William Cohen Article: Watching History Rewritten

What will be fascinating is watching those responsible for allowing the leverage design flaws to persist as they attempt to re-write history. These individuals were given clear warnings and those warnings were ignored. The first of many attempts to obfuscate responsibility might be coming from a one Mr. Summers, who was known as the "enforcer" of the group, which leads us to his comments relative to Ms. Born. Perhaps most egregious of the Summers quotes is the characterization that she prophesized the 2008 financial crisis with a crystal ball, something akin to witchcraft. The article reads:

Born, Summers adds, didn't know what she was attempting to regulate, making it as much of a reach to credit her with prophesizing the financial crisis as it is to hold Rubin or Summers responsible for failing to prevent it.

This is interesting because Ms. Born did not prophesize the financial crisis. She logically identified core structural flaws in leverage design and brought it to public attention. Catastrophic economic collapse was at stake, certain banks were structuring the leveraged products with no central coordination relative to risk management and the products overleveraged nature was opaque. These are the high level concerns, and many destructive leverage issues arose from this understanding.

Those close to Wall Street acknowledge Mr. Summers "poor word choice," but insist Ms Born should not be credited with predicting the financial crisis.

When Ms Born's CFTC identified these issues, the economic control committee, AKA Alan Greenspan, Robert Rubin and Larry Summers, at the dubbed by Time Magazine as "The Committee to Save the World," were doing nothing to prevent the problem.

Much like MF Global insiders who realized working within the system wasn't going to generate justice, Ms Born's only choice was to bring the issues public. The first step to solving any problem is to recognize it. Even Bill Clinton laments later in the Cohan article the fact the true derivative debate remained an unmentionable topic, behind closed doors and under the thumb of the economic control committee, which was part of the problem.

Clinton, too, wishes he had a few mulligans. The president says he raised concerns about derivatives and their lack of regulation to Greenspan, though not to Rubin. "I should have aired the debate we had in private in public," Clinton says, "and at least raised the red flag."

A few mulligans? Summers and Rubin were said to have told Clinton that the derivatives were only used by sophisticated Investors and did not need regulation. Remember, these are instruments that have imploded and will likely do so in the future. The OTC derivatives destroyed the economic climate in 2008 and we are about to see the worst. The OTC derivatives that exploded in 2008 will likely explode again, in the author's opinion, and the risk must be properly identified in order to be managed. Born and her staff understood these derivative "weapons of mass destruction" impacted much more than sophisticated investors. Mr Summers "mis-statements" are now impacting the world. "Clinton was bamboozled and knows it," says an industry source close to CFTC regulatory history, echoing other publicly documented sentiment. (This is a significant issue, and sources have used much harsher words than "bamboozled" to describe the mis-statements from Mr. Summers to President Clinton. Keep these comments in mind when the consequences of the EU leverage implosion becomes known.)

Did Born Understand Derivatives Fundamentals Better than Summers and Rubin?

Some say that not only did Ms. Born understand what she was attempting to regulate better than Summers, Rubin and Greenspan, but perhaps her not taking direct orders from a controlling force trading OTC derivatives that was just the beginning act of a group flexing its Glass-Stiegel muscle - and her speaking out was her undoing. It is the repeal of this law that is being widely pointed to by key Wall Street players as a critical step backwards, a circumstance well memorialized in the Cohen article through comments by John Read, Sandy Wiel and Richard Parsons. Just read an example:

Richard Parsons, the former Citigroup board chairman, told a Washington audience this past spring that "to some extent, what we saw in the 2007-2008 crash was the result of the throwing off of Glass-Steagall." Most famously, Sandy Weill told CNBC in July 2012 that the law's reinstatement in some form is necessary to restore confidence in the financial system. "Have banks be deposit takers, have banks make commercial and real estate loans," Weill said. "And have banks do something that will not risk taxpayer dollars."

In the article, Mr. Summers continues with further obfuscation, something he might have picked up from the master, a certain Fed Chairman from which his marching orders emanated.

"It should be noted," adds Summers, "that the credit-default swaps and the collateralized-debt obligations that were central to the crisis barely existed at the end of the Clinton administration.

Here's a key point. Summers is correct the CDO products barely existed. But he attempts to mask the key fact that the core design flaws in the leverage structure followed its way from 1998 to 2008 and most troublesome to this very moment. The product doesn't matter if the core design flaws remain.

Those familiar with the narrative close to Wall Street banks re-iterate that the products evolved in complexity, and thus to say Ms. Born identified a problem in 1998 is a reach. "Remember, it wasn't until 2004 when Warren Buffett warned of the destructive nature of derivatives," the source said, noting the complexity of the products matured significantly to the point where they have almost mushroomed even further out of control today. "In Born's day there were no CDOs, no synthetic CDOs, no products with such complexity."

This said, in her public statements, corroborated by her close associates, Ms. Born identified fundamental problems; significant design flaws that are the faulty foundation of today's overleveraged world. Just look at the similarities in blow ups. The leverage usage was opaque, highly inter-connected and had the potential for catastrophic loss which was not identified to third party risk managers who could see all the positions. These core fundamentals were violated in 1998, 2008 and are currently on a path to wreck havoc in Europe.

Another similarity is those aware of the problems and in a position to do something were silent. Just like 1998 when regulators were unaware of the devastation potential, today's Fed and it's Too Big to Fail guarantee faces unlimited risk potential. (It is this unlimited liability aspect of the Fed's guarantee that was the subject of one of the eight questions submitted to the Chicago Federal Reserve recently.) As mentioned and worth repeating: neither the Fed nor any government entity could possibly have any idea of how devastating the coming leverage crash might be nor how much a potential bank bailout might cost. That answer is unknowable due to the nature of the derivative contract structure.

Fast forward to today. The leveraged "insurance contracts" that underlie Europe's debt crisis are highly interconnected, opaque and carry the same leverage design flaws as those in 1998 and 2008. Imagine if this leverage bomb blows up in Rome, the implosion is felt almost instantaneously felt in Paris and Munich with a similar powerful force. Unfortunately the only way to prove this point is to watch as a debt crisis spreads across Europe, something everyone should be hoping to avoid. Here's the point Mr. Summers deftly attempts to avoid: While the leveraged products may be different, the consistent leverage design flaw, the worst of the problem, remains today.

Read further in the article to find additional confusing statements which might not be surprising because, after all, he did come from the era of Fed obfuscation.

"Career lawyers at the Fed, the SEC, and the Treasury insisted that the CFTC's proposed approach would raise potentially grave questions about the enforceability of existing contracts," Summers is quoted as saying in the Bloomberg article.

This is slightly odd, appears to be an excuse in search of a historical revision. To my knowledge there was no specific legal verbiage Ms Born had presented, nothing specific enough for legislative action and nothing that could determine the "enforceability of existing contracts." It doesn't take a lawyer to understand such a derivative contract legal determination would require specific language and significant legal effort. Ms Born's and her efforts were documented to have been silenced at the "concept paper" stage, nowhere near the point that specific legal wording for legislation that would determine enforceability.

But more important, one real crux of the issue was the CFTC's legitimacy of requesting regulatory oversight over these overleveraged products that carried design flaws. These contract structures were viewed as "look-alike contracts, carbon copies of futures contracts; they were seen by many as an effort to circumvent CFTC regulation," according to another former CFTC legal source. "Furthermore, regulated entities like commodity pools and hedge funds were becoming active with these products," she said, noting the legitimacy for the CFTC to regulate these markets.

A source intimate with Wall Street accurately counters that the CFTC is not the panacea. "Just having the CFTC involved would not have prevented the problem."

The CFTC comes with no guarantee of crisis prevention, that is clear. Typically, however, the best leverage management is transparent, where the overall all risk is known and managed are fundamental principles of proper risk assessments. It could be said that, had leverage management fundamentals been in place, the problems might have been discovered and solutions developed, but such hindsight speculation is now easy.

It is this logical precept, that those familiar with leverage usage should regulate derivative contract structures using the fundamental principles of leverage management, was challenged by a powerful individuals who ultimately prevailed. However, the design flaws they fought for are now about to show themselves again. The fallout from these derivative contracts grows worse with time: 2008 was much worse than 1998 and the logical argument that, unless recognized and addressed, the next crash could be one of historical proportion.

Attempts to Obfuscate Facts, Problem With Female Leaders

Those attempting to re-write history appear to obfuscate the basic fact that all Ms. Born wanted was transparency to understand the extent of the potential consequences so as to risk manage the situation

They want to hide the fact they fought against fundamental principles.  It was this concept that was key. While she did ask for broad regulatory involvement, the fact is the concept paper never got off the ground so actually proposing legislation or regulatory scheme would be premature. According to sources, Ms. Born's actions could be interpreted as proposing the general concept that proper derivative risk management dictates that leverage usage with catastrophic consequences should be transparent, at least to government officials.

In Ms. Born's "Concept Release Paper," distributed by the CFTC on May 7, 1998 , elicited a very strong response from the Rubin / Summers team. They first issued a press release, but more significant were their maneuvers to muzzle her voice and diminish her influence. The real concern behind the scenes, according to sources intimate with maneuvers of large Wall Street banks, was the notion that Ms. Born was engaged in some sort of a power grab, "getting ahead of her skis." Further, Summers and his group didn't want a woman head of the CFTC starting to control a lucrative piece of business.

Aggressive Tactics Used to Oust Ms. Born: Speaking Out Has Reputational Risk For Women

Behind closed doors Born might have mused as to the absurdity of this dangerous flaw in derivative management, but she mostly held her tongue in public regarding anything that would have questioned the economic control committee's reputation. 

The same was not true of the opposition, according to sources, who describe Mr. Summers as particularly aggressive with Ms Born. Don't forget, Ms. Born was a female from a different generation, one of the first women breaking through the glass ceiling. At the time, a woman with this sort of authority questioning her superior male counterpart might not be the norm. In this case, sources say Mr. Summers bullied Ms. Born in a way he likely wouldn't had Ms. Born been a male. "Disgusting," is how one source described it, while "vicious" is a comment heard more often. Born, for her part, remained the consummate female professional, refusing to engage in public questioning of her attacker's reputation. Her comments or public criticism of the matter rarely appear in print. She refused to comment for the Cohan article. She was not asked to comment for this article and is not involved in any of the conclusions.

A source inside Wall Street notes that Mr. Summers is concerned that Ms. Born is being lionized for a feat she couldn't have possibly predicted. Further, concerns are that Mr. Summers will be blamed if the overleveraged debt crisis does comes to a head and the unregulated OTC derivatives do fail under the stress, which could be unfair.

What Really Happened at the CFTC During Born Tenure?

Much like the US debt crisis and MF Global, occasionally transparency in financial services has benefits of cleaning out a system. Ms Born had no idea exactly how or when the improperly designed leverage products would implode, but like a structural engineer noting flaws in a bridge design, she knew at some point the flawed system would discover gravity. Transparency, recognizing interconnected risk and understanding leverage usage were all commodity industry fundamentals that were being trampled. She knew unsustainable leverage management when she saw it; her logical prediction, almost mathematical in nature, was fundamental to those familiar with leverage management.

Born Detractors Note Regulatory Overreach / Political Stumbles

For all the Born backers, she does have detractors within the regulated futures industry as well as Wall Street. Some sources call her attempts to "play with the big boys" a demonstration in immature political gamesmanship. Others, however, point to a potential regulatory overreach. "Even if she was right, which history is tending to prove over and over again," said one source, "The fact is she was fighting a losing battle. 1998 was the start of a war for the sole of a regulator, and her regulatory overreach and high-level political inexperience allowed them their first major victory in a fight for transparency and appropriate regulation."

A Wall Street source sums the situation by saying that in 1998 no one really noticed the CFTC nor understood the significance of the leveraged derivatives. During the crisis of 2007-08, thoughtful people looked back and tried to determine the seeds of the destruction. Some say it was leverage usage, which was identified in a William Cohan article written in the Atlantic in 2004. Some looked at Born and may have found a simple savior. This was the first real attention the issue received.

"It's not as clear cut as the David vs the Goliath," said the Wall Street source. "One can't go back with 20/20 hindsight and say the CFTC should have regulated these derivatives."

While those on Wall Street plant seed of doubt as to the relevance of Born's historic warning, some in the commodity industry also cast a realistic shadow.

"Demure was not a word I would use to describe Brooksley," said a former CFTC legal source involved in writing market standards."She had a roster of large corporate clients before leaving Arnold & Porter for the CFTC. You can't be demure and represent such people. Also, she was a senior player in the American Bar Association, something that required an appreciation of, and an ability to participate in, political maneuvering."

So what happened? "Many different people with different agendas came to the same conclusion: Brooksley was taking the first step to assure that the CFTC was the regulator of this previously unregulated market. First, the SEC saw it as a power grab. They wanted jurisdiction. Second, ISDA was very powerful with Senate and House members at that time. Their lobbyists were very effective; they had a huge war chest to contribute to members of Congress voting their way. They did not under any circumstances want anyone regulating swaps. Then, there was Mr. Greenspan, who did not believe in regulation. Robert Rubin came from the industry that was earning huge sums from serving as counterparty in swap transactions. Finally, Larry Summers was an academic who may have felt like Greenspan or owed loyalty to Rubin. In any event, he would show repeatedly his discomfort with women in high positions."

Brooksley faced this group head on, and this is where the political skills came into place.

"It's important to put the CFTC into perspective at the time," said a commodity industry source. The agency at first regulated real things, agricultural commodities. But that started to slowly change with the introduction of financial futures, lines were blurred. The SEC was doing nothing to regulate the OTC derivatives, they were influenced to a great degree by the Wall Street banks. When Born even suggested any regulation whatsoever, those engaged in OTC transactions "freaked out," according to the source. Their answer was to take over the agency, appointing the likes of Wendy Graham and Gary Gensler, known to be kind to their needs. Born was a real regulator. The Wall Street 'Blob' killed her and the CFTC is now captured, claimed the source.

"At the time, many of us wondered how she could have let herself appear so naive in these political battles," said a different commodity industry source. "Could she have accomplished more if she spent more time explaining to Congress or to President Clinton why her position was appropriate? It seems that she did not. On the other hand, with such a group of adversaries--each with their own reasons for fighting her proposal--perhaps it didn't matter what she did. The CFTC was a backwater agency. Its Chairmen and Chairwomen had, for the most part, been undistinguished. It was compared unfavorably to the SEC. A brilliant lawyer, she tried to change the agency's reputation. Unfortunately, the issue was much too complex and had too many adversaries. The opposition was much more than just Greenspan, Rubin and Summers."

In hindsight, one might question if Brooksley should have spoken the truth in public? It might be considered that making her serious issues transparent might have been the key to winning the battle. When the issues are on your side, air them in public; when issues benefit a small minority, as the blob does, keep the issues in the shadows. While Brooksley lost in 1998, does her battle live on? As the US is facing the unlimited loss potential of a European debt crisis, shouldn't the core issues, the fundamental problems with OTC leverage design be addressed without a small minority blob extracting the benefit of an unlimited loss insurance? These are serious issues of today that might be framed from Brooksley's decision not to speak her mind in public.

Was it wrong for Brooksley not to speak her mind at the time?

Look at the societal picture at the time. Women were just starting to crack the glass ceiling, certain men were getting upset, some would even lash out at women in a way they would not to a man. Some viewed this behavior as generally acceptable at the time, while others might have viewed it as a controlling force lacking an open mind. History can judge. When Ms Born spoke the fundamental truth in 1998 it was during a period of acknowledged gender repression. For Ms Born to stand up to a man was unique, it was bold. For this stand she was clearly punished on several levels.

Where is this story going and what is the genesis of the problems? A top Wall Street source intimately familiar with the maneuvers of large banks trading OTC perhaps has the best arc on the larger perspective. "We're going through three phases with this story," said the Wall Street source. The first phase Born was shut down, nobody on Wall Street knew who she was nor did they pay attention to the issue. The second phase was looking at the problems in 2008 and then they discovered Born. The third phase is now Larry Summers putting his spin on the historical record.

Born's Struggle Continues Against the Backdrop of a US Debt Crisis

What's most amazing about this struggle is it continues today. The goal of Ms. Born's warning was to generate public awareness so as to facilitate positive change. The same is true of MF Global and the US Debt crisis, all of which are in need of helpful transparency.

Is the answer transparency and fundamental derivative management or a combination? "Until you change the compensation structure on Wall Street back to the days when they were private partnerships with their own capital at risk, there is no way you can reign in their bad behavior," said one source.

1998 was the year Brooksley Born was forced from office for standing up for fundamental economic principles and market integrity, according to some in the commodity industry. When she was unceremoniously forced from office in 1998, the large entities engaging in flawed OTC derivative swaps first got their taste of regulator blood. Ms. Born's sin, you may ask? She raised a red flag on fundamental issues that now have potential to implode again. It was this moment, in 1998 when this minority force in the financial services world now exerted super-majority control. This control led to excesses in 2008 and will likely implode again.

"After 2008, there was an obvious need for change," said the Wall Street source, who noted Obama appointed the wrong Wall Street crew. "It was hugely disappointing, a major missed opportunity."

The Brooksley Born incident is documented history. So now recognize how those - involved behind the scenes are attempting to rewrite that history - a history where their early handiwork the foundation for perhaps where the most significant leverage implosions are likely yet to occur.

"Born may have been guilty of not knowing how to play the game and trying to expand her agency in a precarious time," said one source.  "But she was motivated by doing the right thing more than politics. That is really why she was knocked off."

Related Reading:

Related Documentary:

Reasons Why Writing This Article and Discussing the Issues Is Important

I've been asked by a good friend who is behind the disclosure of information? The answer is that I am solely responsible. Why am I doing this? The economic world is on an unsustainable glide path that must be corrected. Relying on the economic control committee to take care of issues behind the scenes doesn't work. They were warned about leverage design problems in 1998, again in 2008 and continue to disregard the warnings. Just like MF Global, another instance when the economic control committee told us to be quiet and happy with 60% of customer funds returned by July 2012, its time to logically question this country's opaquely managed economic direction. Transparency is the best disinfectant.

Some people ask why I quote "sources." Here is the fact Brooksley Born demonstrated: speaking up for truth and fundamental market principles has a cost. The sources quoted in this article would likely face retribution for speaking up, much as Brooksley paid a price. The managed futures industry isn't perfect, but at least we mostly play by a reasonable set of rules.



 
This article was published in Opalesque Futures Intelligence.
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  3. Europe - Hedge funds face exit tax as Iceland central bank discusses plan[more]

    From Bloomberg.com: Hedge funds and other creditors with claims against Iceland’s failed banks face an exit tax as the island looks for ways to unwind capital controls without hurting the economy. The government targets having a plan it can present by year-end that would map out how Iceland will sca

  4. Opalesque Exclusive: Risk management emerges as a competitive focus area for hedge funds[more]

    Bailey McCann, Opalesque New York: Risk management has always been a core component of any trading strategy, as well as a critical part of business management. However, as macreconomic weakness persists, and alpha becomes increasingly hard to generate, risk management as emerged as a more promin

  5. Gross: Inflation is required to pay for prior inflation[more]

    Benedicte Gravrand, Opalesque Geneva: As inflation rises, every dollar will buy a smaller percentage of a good. While deflation will mean a decrease in the general price level of goods and services. These two economic conditions are both in the waiting room. The consensus would like the former to