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Pat Toomey: The Wall Street Years

How the front-runner in Pennsylvania's Senate race was at the forefront of the type of risky deals that have put American towns and school districts on the brink of fiscal ruin.

| Tue Oct. 5, 2010 5:00 AM EDT

None of the early derivative disasters seemed to have an impact on Toomey's boosterism for the industry. When he came to Congress, he was on a mission. "The trend in deregulation, beginning in the early 1980s, is one of the biggest reasons for the sustained economic expansion," he told Derivatives Strategy. "I would like to see us continue to deregulate on many fronts, including the financial services industry." Toomey worked hard to make that happen. Sestak has attacked Toomey for helping to draft bipartisan legislation that repealed the Glass-Steagall act, allowing banks to combine their investment banking and commercial divisions—and to become the behemoths that later had to be bailed out by taxpayers. But economists differ over whether Glass-Steagall repeal exacerbated the economic crisis. 

What economists do agree on is that the lack of regulation of derivatives—especially newly invented types of credit and equity swaps—was a major factor leading to the financial meltdown. The Glass-Steagall repeal bill also included a provision dealing with—or rather failing to deal with—derivatives regulation. Most members of Congress who voted for the bill focused on the Glass-Steagall bit. But Toomey—whom the derivatives industry saw as "one of its own"—zeroed in on the derivatives element. "I'm particularly pleased this bill contains an important provision and equity swaps," Toomey said in a November 1999 speech on the House floor. He went on to say that swaps were already "adequately regulated" and would "continue" to be regulated by banking supervisors, state-level officials with little power over national financial markets. 

There was a lot of financial deregulation in 1999 and 2000, and Glass-Steagall repeal was just a part of it. In December 2000, Sen. Phil Gramm (R-Texas), a right-wing economist who went on to become John McCain's economic adviser (he's the one who said America was a "nation of whiners"), inserted an 262-page law called the Commodity Futures Modernization Act (CFMA) into an unrelated bill. (Read more about "Foreclosure Phil.")

The CFMA basically ensured the full deregulation of derivatives—completing the process that had begun in the UK in 1986. It was introduced on a Friday night two days after the Supreme Court's Bush v. Gore decision and right before the Christmas recess. For better or worse (well, for worse), most members of Congress didn't even read the CFMA or know what it did. It passed overwhelmingly because few people understood it, and it was attached to a 11,000-page, must-pass, pork-stuffed appropriations bill that was going to pass anyway. (Wendy Gramm, Phil Gramm's wife, had been a key player in the partial derivatives deregulation from 1988 to 1993, when she was at the CFTC.)

Unlike most members of Congress, Toomey, the former derivatives trader, knew exactly what was going on with the CFMA—and had been pushing for it for months. In October, he had urged Congress to pass a similar bill—saying that it would "eliminate most of the cloud of legal and regulatory uncertainty that has shadowed" derivatives since their invention. Two months before that, he boasted to a House banking committee hearing that the derivatives industry "has done enormous good and has been an enormous force for positive change in our economy generally." 

Toomey's derivatives cheerleading continued for the duration of his time in Congress. In 2001, he boasted on a campaign website that he had been "putting his experience in International finance to work" on "important legislation," including the "authorization of derivatives trading." In 2003, he praised the expansion of the derivatives market as "perhaps the most important, creative and innovative development in finance in the last 30 years."

By the time of the 2008 crash, derivative swaps had grown into a market with a notional worldwide value of $600 trillion—ten times the annual output of every economy in the world. The state banking supervisors who Toomey said would "continue to regulate" swaps did nothing while traders at Merrill Lynch, Lehman Brothers, Bear Stearns, and AIG made bets they couldn't possibly pay out on. Eventually, the system collapsed on itself.

Toomey didn't see it coming. In fact, he has a history of playing down the threat of systemic financial problems. The planners of the 1998 LTCM hedge fund bailout were hailed on the cover of Time magazine as the "Committee to Save the World." But for Toomey, the lesson of the committee's work was not that the financial system was fragile or that highly leveraged financial institutions could bring others down with them. Nor was it that unregulated, off-exchange derivatives trading could lead to disaster. Instead, he promised Derivatives Strategy readers that he would "resist...any effort to impose inappropriate regulations." After all, he said, LTCM was a "big problem" that was "essentially solved." Not everyone agrees. "I have found virtually no evidence that the legalization of speculative derivatives did anything other than increase systemic risk," Stout says.

In some sense, Toomey's triumphalist attitude towards derivatives is unsurprising. It's not just because his ideological conservatism predisposes him to loathe regulation. It's also because unregulated trading of derivatives benefited him and his family. As Upton Sinclair said, "It is difficult to get a man to understand something, when his salary depends upon his not understanding it!" But perhaps a quote from Derivatives Strategy is more appropriate. After hearing Toomey's positions on regulation, the trade paper rejoiced. Toomey's "passionate discourse is music to the ears of derivatives players around the country," the paper reported. And indeed it was. Unfortunately, things didn't work out too well for the rest of us.

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