Sunday, March 15, 2009

Bucket Shops and Credit Default Swaps

This Sunday (March 15, 2009) the New York Times carried an opinion piece titled: Following The A.I.G. Money.

The article said that the now infamous credit default swaps, often referred to as a form of insurance, were more like gambling wagers than insurance policies. Huh? I did a Google search for more information.

I learned that 60 Minutes did a piece last October called The Bet That Blew Up Wall Street. It was an investigation into the central role credit default swaps played in the present global economic upheaval.

As everyone now knows, Warren Buffet called credit default swaps “financial weapons of mass destruction.” For most of the 20th century the present deep, unregulated involvement of the large American banks in the world of derivatives was illegal. But in 2000 Congress changed the law, passed the Commodity Futures Modernization Act of 2000 and exempted Wall Street. It seems odd, but page 262 of the legislation prevents states from invoking existing gambling and bucket shop laws against Wall Street. Gambling? Bucket shops?

What, pray tell, are bucket shops? Well, before the stock market crash of 1907 American cities had gaming houses called bucket shops where gamblers placed bets on whether the price of a stock would go up or down. The speculators did not have to own the stock to profit. They were making, as they say, a side bet – a bet, usually made by gamblers on the outcome of an event, say a poker hand. You don’t have to be a participant in the event to place a side bet.

Like gamblers, the players in the credit default swap market did not have to have, as they say, skin in the game. It was a side bet. They did not have to own the investment on which they were buying private insurance contract – contracts that paid off if the investment, say certain mortgage securities, went bad. They didn't have to own the investment to collect on the insurance – memories of the bucket shops.

Recently Alan Greenspan, the Federal Reserve Chairman at the time, admitted he had put too much faith in the self-correcting power of free markets. A humbled Greenspan acknowledged that he had discovered a flaw in his ideology. He told the House Committee on Oversight and Government Reform, “Those of us who have looked to the self-interest of lending institutions to protect shareholders’ equity, myself included, are in a state of shocked disbelief.”

Under Greenspan the credit default market grew from millions of dollars to a more than $50 trillion dollar monster – and totally unregulated. Neither the big banks nor the investment houses that sold these derivatives set aside the money necessary to cover their potential losses and pay off their bets, a result of deregulation. When the derivative market turned south, and with no money behind their quickly souring obligations, the big players, among them Bear Sterns, Lehman Brothers and A.I.G., all found themselves not on the hook but hoisted painfully high on their own petards.

Rep. Henry Waxman, chairman of the house committee, asked Greenspan if he had learned that his view of the world was not right. Greenspan confessed he had. He said he had “found a flaw” in his personal ideology and he was shocked by his discovery.

“This crisis,” Greenspan has now admitted, “has turned out to be much broader than anything I could have imagined.” And yet, there are still bonuses being doled out on Wall Street.

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