Opinion

David Cay Johnston

Closing Wall Street’s casino

By David Cay Johnston
November 18, 2011

The author is a Reuters columnist. The opinions expressed are his own.

A superb example of a sound rule in law and economics that needs reviving, because it can halt the rampant speculation in derivatives, is the ancient legal principle that gambling debts are not enforceable through court action.

Not so long ago — before casinos, currency and commodities speculation, and credit default swaps became big business — U.S. courts would not enforce gambling debts.

Restoring this principle offers a simple way to shrink the rampant speculation in derivatives that was central to the 2008 meltdown on Wall Street.

Professor Lynn Stout, a deeply principled Republican capitalist who teaches corporate law at the University of California, Los Angeles, raised this issue at a conference where we both spoke about the 2008 Wall Street meltdown.

“Derivatives are gambling,” she said, referring to credit default swaps, at the University of Missouri-Kansas City law school conference on the financial crisis. “They are a zero-sum game in which one side loses the bet and one side wins,” Stout said.

Actually they are worse than that, since the hefty fees Wall Street pockets for arranging the bets result in a less-than-zero-sum game.

As Wall Street fights meaningful financial regulations, and draft regulations remind us how complex and unfathomable regulations can be, this is a good time to remember the basic principles that served society so well until Chicago School theorists, and casino corporations, together with commodities and currency traders convinced us we were too modern to need them.

UNENFORCEABLE GAMBLING DEBTS

Stout recounted the history of unenforceable gambling debts back to the Romans. She cited an 1884 Supreme Court case on what were then called “difference contracts” to show that derivatives have a long history of being treated by the law as unproductive at best and often damaging to society, just as we saw in 2008.

“I have not found a successful economy that did not have legal restrictions on bets,” she said.

She said that in addition to being nonproductive, such bets add risk to the system, invite bad conduct because bets can be rigged and foster asset bubbles, which are inevitably followed by crashes like the one from which we still have yet to recover.

As the author of a book on the gambling industry’s rise, “Temples of Chance,” and as a lecturer at Syracuse University on the regulatory law of the ancient world, I recognized Stout’s points were spot on. But her warnings are being drowned out by radical anti-regulatory rhetoric, the army of Capitol Hill lobbyists working for derivatives sellers and the politicians to whom they donate.

Stout noted that speculators these days like to call themselves by other names — for instance, hedge fund managers. But hedging suggests engagement in a business such as oil or grain and buying or selling contracts backed by assets you have or will use.

PURE SPECULATION

Most of the bets on Wall Street were pure speculation. Against $15 trillion of mortgage bonds, Stout said, Wall Street marketed credit default swaps in 2008 with a notional value of $67 trillion. Worldwide, traded swaps at their peak equaled $670 trillion or $100,000 for each person on the planet, vastly more than all the wealth in the world. Those numbers make it a mathematical certainty that the swaps were mostly speculation, not hedging.

Stout likened some derivatives to a market in fire insurance in which you buy coverage not for your own home, but for those of strangers. Such insurance would create an incentive to commit arson for profit. Yet we allow speculative derivatives that melted the housing market.

Stout’s approach would not stop derivatives that are backed by hard assets, such as a mortgage whose interest rate is derived from an index like the London Interbank Offered Rate or Libor and thus varies over time.

But credit default swaps that are just bets on which one party wins and which one loses would vanish if we restored the ancient, time-tested and therefore profoundly conservative rule that government will not enforce the collection of gambling debts.

Making gambling debts unenforceable produced its own problems. For one, it created work for people like the late Harry Coloduros, who sat in my kitchen 25 years ago, bouncing my little Molly on his knee as I made coffee, and told me about gamblers he beat up to make them pay up.

I cannot imagine Goldman Sachs hiring the likes of Harry to collect on bets when the losing party fails to pay up. So, unless taxpayers cover the bets, as they were forced to at 100 cents on the dollar in the AIG wagers, Goldman would likely get out of speculative bets and stick to actual hedging.

And that shows the immense value of restoring the sound policy of making losing bettors suffer their losses without any help from government.

Comments
17 comments so far | RSS Comments RSS

Precisely! And playing with “house” money to boot, our houses. At its core, WallStreet Stocks never were a value-backed asset, their vlaue an illusion of traders proclivities, a “ponzi” scheme, that works and feels good on the way up, just long enough to have the entire country believing in it like religion, the banksters “stock in trade” for funneling everyone’s investments, retirement and pensions. All gone, and nowhere to find work now either to make up for the losses, meanwhile trillions just borrowed (created) to keep the casino doors open. Thanks http://youtu.be/pkrFdxpXQMI http://youtu.be/slhO503-HE0

Posted by ausesq7 | Report as abusive
 

Let’s apply your theory to a real-world application – the corn futures market at the Chicago Board of Trade, a derivatives market that has been around for roughly 150 years. What would be the impact of forbidding anyone who does not either grow corn or process corn from trading in these markets?

Right off the bat, the results would be fewer traders participating in these markets (hard to argue that one), and as a result, lower volumes, wider spreads and thus higher costs for using these markets, which would then be paid by farmers, grain processors or, most likely, by the end users of these products: you and me.

Yay for regulation!

Also, I’m unclear about the statement about not “stopping” derivatives based on hard assets, as these are somehow more legitimate when compared to something like a credit default swap. Credit default swaps are insurance, just like put options on a stock are insurance.

Why aren’t you recommending that people stop trading in put options too? It’s the exact same argument, instead of buying and selling insurance on a bond, you’re buying and selling insurance on a stock … and you don’t even have to own the stock!

The reason you don’t hear a hue and cry about trading in put options is that put options (in the US at least) are traded on organized, transparent, centralized exchanges and so trading activity is completely visible, positions are margined daily and anyone with a few thousand dollars can participate.

Compare this to the credit default swap market, which is opaque, requires participants to have tens, if not hundreds, of millions of dollars to participate (thus limiting liquidity) and risk management is done however the big banks want.

That’s where the problem lies, not in the fact that people are speculating. Unless you’re a monopoly, every business involves speculation.

Posted by furytrader | Report as abusive
 

Well said. The US has fostered too many self interested individuals that took the nation for a ride. Perhaps, having jail sentences for executives that bankrupt their companies should be restored as a deterrent against those self promoters whose abilities fall short of their gift of the gap.

Posted by MYap | Report as abusive
 

The “bettors” have the US taxpayer to pay for their losses through the “strong arm” action of the “henchmen” with money backed power. Wealth is not intrinsically harmful, it’s how you use it that can cause havoc to the commons.

Posted by Al100 | Report as abusive
 

> “Worldwide, traded swaps at their peak equaled $670 trillion or $100,000 for each person on the planet, vastly more than all the wealth in the world. Those numbers make it a mathematical certainty that the swaps were mostly speculation, not hedging.”

This is incredible! I always thought it would take a microscope or x-ray vision to find more than the minority of corruption in our society. But talk about an “elephant in the room”… Our banking system is full of it, and the world not far behind them. No wonder we’ve hit an economic down-turn if the people responsible for those trades have somehow persuaded our political representatives that the economic system was about to disintegrate at the seams if public funds weren’t misappropriated to compensate the losing bettors for their losses! Those miscreants effectively held the system to ransom, and won…

Posted by matthewslyman | Report as abusive
 

This could be the answer it needs shouting from the roof tops!

Posted by Gillyp | Report as abusive
 

the banking industry is like the tobacco industry etc…careless and dangerous; the community needs strong protection against this kind of toxic self forming human rings; not everybody is a genuine decently paid nurse, fireman, schoolteacher;

Posted by Paats-W. | Report as abusive
 

The problem is that you could make the same argument about the insurance industry or the agricultural futures market – these are bets also and CDSs can be looked at as an insurance policy. Maybe what needs to be addressed is whether something “tangible” is being insured, and not an insurance policy on an insurance policy on an insurance policy, etc.

Posted by stevez3 | Report as abusive
 

Further, what is really wrong is that CDSs are not conducted in an open market and are not regulated – no one know who and how much; so risk is impossible to assess. Further, it is said that 5 banks do more than 90% of the CDS on sovereign debt – are they is a financial position to cover potential claims? Probably not and who knows? Derivatives per se are a great thing, I like being able to limit my liability. What is needed is regulation/transparency.

Posted by stevez3 | Report as abusive
 

Great article.

Sad to say, President Obama, whom I mistakenly voted for, is in the bankers’ pockets. He talked change. Then he changed almost nothing.

We need a fighter, like Teddy Roosevelt, or a Harry Truman, to take on Wall Street’s powerful casino. Obama doesn’t have the temperment.

Posted by AdamSmith | Report as abusive
 

“I cannot imagine Goldman Sachs hiring the likes of Harry to collect on bets when the losing party fails to pay up.”

Excellent article. But can you imagine Deutsche Bank and Credit Suisse hiring Karatzaferis and Plevris to beat up on the Greek people?

Posted by Thorstein | Report as abusive
 

This has been going on for a lot longer than Obama, GW Bush, Clinto, GWHB have been Presidents. Until it is stopped by a new set of people in congress, it will go on as they are all beholden to their corporate masters. Or, until the people rise up and take their revenge.

Posted by 742 | Report as abusive
 

The errors and misconceptions in this article are so numerous it is laughable.

Does the author know or care to explain the difference between notional and vet value? Anyone with even a basic understanding of derivatives or how the financial markets work would make a clear distinction between the two and list net value, not notional value.

To all readers who don’t know the difference either, please contain you incredulity until you become better informed.

Shame on Reuters.

Posted by DanielKneal | Report as abusive
 

What a brilliant concept – all the better for being ‘conservative’ (difficult for at least one of the Parties to disagree with) and costing the taxpayer nothing to administer.

Posted by politediscourse | Report as abusive
 

Great as always. I looked up the derivative market today and it was 167 Trillion, with a T. That is measured against a $15Trillion national debt, which is about the same as our GDP which is listed as a quarter of the worlds total output. (all measured in those stretchy US dollars. One of your commenters mentioned $670Trillion and another internet artilcle mentioned $1,200Trillion, but they said quadrillion and it all gets silly.)

Casino is the word; Betting two and a half times the entire house… if this world is a house. OK, I am not nearly as careful as Mr. Johnston, in sourcing my figures. But for crying out loud, aren’t vast amounts of those bets put down by what we used to call banks? Who handed the craps handlers our wallets, for some few of us still work for the stuff.

So here is my question Mr. Johnston. Who are the ‘bond vigilantes”? What responsible parties seem to have the economic reins over the political stability of Europe and are threatening, threatening.

Outta control, yet in control of our political levers. It is enough to make an old buzzard occupy.

They are more than betting the farm. Betting the other guy’s farm.

Posted by TheOldSodbuster | Report as abusive
 

You forgot to mention that credit default swaps are INSURED! Who insures them- that’s another serious issue and should be outlawed. CDS’s almost wiped out Japan after the earthquake & are currently trashing the euro. Thety need to be stopped- they have more power than governments.

Posted by spiderbite | Report as abusive
 

@AdamSmith

“We need a fighter”. How about Elizabeth Warren in the future?

Posted by KyuuAL | Report as abusive
 

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