On Bucket Shops and Crises

Compliments of Naked Capitalism, here is a large excerpt from an article in today's Financial Times (London), by Eric Dinallo, New York State's Superintendent of Insurance, on some historical background relating to Credit Default Swaps.

Many compare this financial crisis to the stock market crash of 1929, but it is closer to the credit freeze and bank panic of 1907....

The bank panic of 1907 is remembered for J.P. Morgan forcing all the bankers to stay in a room until they agreed to contribute to fixing the crisis. What has been forgotten is one major cause of the crisis – unregulated speculation on the prices of securities by people who did not own them. These betting parlours, or fake exchanges, were called bucket shops because the bets were literally placed in buckets.

The states responded in 1908 by passing anti-bucket shop and gambling laws, outlawing the activity that helped to ruin that economy.

What has that got to do with today’s crisis? Credit default swaps are the rocket fuel that turned the subprime mortgage fire into a conflagration....AIG Financial Products, the unit that sold almost $500bn (€379bn, £353bn) of them, may therefore be viewed as the biggest bucket shop in history.

Credit default swaps started out as essentially an insurance policy. If you owned a bond in a company and were concerned it might default, you bought the swap to protect yourself....Banks bought them to reduce the amount of capital they were required to hold against investments – in other words, to avoid regulation. Because they owned the swap, banks claimed they no longer had the risk of a default of the bond. Others bought swaps without owning the bond to place a bet on a company’s future.

But there was serious concern that swaps violated the old bucket shop laws. Thus, the Commodity Futures Modernisation Act of 2000 exempted credit default swaps from these laws. The act also exempted them from regulation by the Commodities and Futures Trading Commission and the Securities and Exchange Commission. Unregulated, the market grew enormously.

Thus, one of the major causes of the financial crisis was not how lax our regulation, or how hard we enforced, but what we chose not to regulate.

Indeed, what we decided was old fashioned and in need of modernisation was, in fact, an effective check on an activity that for 100 years had been illegal, for good reason. As a result, we modernised ourselves into this ice age.

The fear in 2000 was that if we regulated credit default swaps and required holding sufficient capital, the market would go where unregulated sellers could make more money. We forgot that the biggest competitive advantage of the US financial system has always been safety, security and transparency. If we destroy that perception, the long-term cost to our society is incalculable.

While I am sure that Mr. Dinallo's historical facts are correct, perhaps some points may be added.

One is that the buildup of debt is similar to 1929, and not to 1907; the global nature of the current situation is like that of the Great Depression, not thatof 1907; and there was intense stock speculation both in 1906-7 and in 1927-9.  There are many parents to the current problem.  In addition, what we have now that is unique to today is intense government money printing and borrowing to "stimulate" the economy. 

The recommendation from EBR has been and is to simply ban credit default swaps.  If you don't like the loan, don't make it.  If it's to large for you to make but you like it, find partners.  And make lots of loans, thus obtaining your protection.  Unfortunately, the G30, which is led by an AIG Vice President and has Paul Volcker as a figurehead Chairman of the Board; and which is sponsored by Riskmetrics, is getting its way in that Timothy Geithner is using its industry-friendly viewpoint in his proposal for regulation rather than real reform of the financial industry.  Thus will the seeds be ready to turn into tinder to fuel the next "banking" crisis.

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