The Great Debate

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.

By Roger Martin
The views expressed are his own.

The three-week old, 60’s-style Occupy Wall Street protest raises once again the question that won’t go away: What on earth were those bankers doing in the period leading up to the 2008 financial meltdown? This street-level insurgency combines with last month’s smackdown-from-on-high administered by the U.S. Federal Housing Finance Authority’s (FHFA), which sued 17 leading global financial institutions for $196 billion, charging that they knowingly peddled shoddy mortgage-backed security products to unsuspecting customers. With the European financial system continuing to teeter on the brink due to the massive bank losses and bailouts, the U.S. economy stagnating and its equity markets close to free-fall, the answer of Chuck Prince, former Citigroup chair, that “we danced until the music stopped” has not mollified either Occupy Wall Street or the FHFA, or anybody else for that matter.

It is obvious that they did keep dancing.  But it leaves unanswered the question: Why did it make sense to them to keep dancing?  And also: When the music did finally stop, how did we manage to have asset-backed derivatives contracts outstanding with an estimated value of three times the size of global GDP?

The answer was that thanks to the structure of their compensation, major bank CEOs were obsessed with their stock price and trying to keep beating expectations until the music stopped.  And the asset-based derivatives market was their clever device for beating expectations for much longer than could have happened before – because it was the world’s first market of infinite size. And it worked for them.  When the music stopped and expectations came crashing down, they were by and large wildly rich.

Senate Democrats have beaten back an ambitious, industry-supported amendment to the derivatives portion of financial reform legislation.

If passed it would have significantly weakened the administration’s efforts to tighten regulation of over the counter derivatives markets.

Yesterday’s vote went largely along party the lines (39-59). But Senate Democrats attracted support from moderate Republicans Olympia Snowe (Maine) and Charles Grassley (Iowa), making that part of the bill effectively filibuster proof.

- Steven Miller is managing director of Standard & Poor’s LCD, a unit not part of Standard & Poor’s ratings business. The opinions are his own and not those of S&P.-

As the worst credit crisis since the 1930s recedes, investors are starting to boil down the lessons of the past two and a half years.

With time, we’ll get smarter about how to interpret the recent upheaval but for now, it comes down to these: (1) financial covenants, which test the financial health of a borrower each quarter, can be used to reset loan spreads when times are tough, (2) collateral is indeed resilient, (3) bubbles work in both directions, (4) models are better at predicting the past than the future and (5) “black swans” –- those big unexpected events and their consequences — take many forms.

In 1873, Walter Bagehot wrote that "the business of banking ought to be simple; if it is hard it is wrong." He would have struggled to recognize today's banking system.

It is not just ever more ornate derivatives that bend the mind. Financial firms themselves have become fabulously complicated. Citigroup lists 2,061 subsidiaries and affiliates while the institutional chart of JPMorgan Chase is 267 pages long.

Complexity -- as Bagehot predicted -- has become a curse. If nobody can understand financial firms, they will become ever more accident prone.

The Obama administration's plan for reining in derivatives leaves unchecked one of Wall Street's dirty little secrets: the ability of a derivatives dealer to redeploy cash collateral that gets posted by one of its trading partners.

On Wall Street, this practice of taking collateral and reusing it is called rehypothecation. In essence, it's a form of free money for derivatives dealers to use as they please -- even to repost it as collateral to finance their parent company's own borrowings.

And we're talking big bucks. The International Swaps and Derivatives Association recently reported that derivatives dealers have taken in $4 trillion in collateral from their trading partners. That's an 86 percent increase over the $2.1 trillion in cash collateral those same dealers reported having on their books in early 2008.