Sunday, November 20, 2011

Are Derivatives Contracts Nothing More than Unenforceable Gambling Debts?

We've touched on the fact that Wall Street is exempted from state anti-gambling and anti-bucket shop laws by Federal pre-emption. In July 2010 it was "Financial Reform: Enforce New York's 1908 Bucket Shop Law and trash the 2,319 Page Dodd-Frank Bill":
It is time to dispense with this congressional foolishness and enforce the 1908 Bucket Shop law.
Throw in some state anti-gambling statutes and you would have prevented the financial meltdown....
In October of that year it was "JPMorgan Chase Prevails in Lobbying Battle of Big Banks" (JPM; BAC; C; WFC; USB):
It really is time to revisit the whole Corporate Personhood question. One stupid Supreme Court decision, Santa Clara County v. Southern Pacific Railroad, enshrines the abomination.

The Declaration of Independence was written for Natural persons. Here's a version for corps.
We hold these truths to be self-evident, that all Corporations are created equal, that they are endowed by their Creator (us by way of state legislators) with certain alienable Rights...
If proponents of the legal fiction can figure out a way to, for example, imprison a corporation for criminal activity I might be willing to change my opinion on the matter.

As far as bank regulation goes, I'm looking for the next Congress to repeal the bought-and-paid-for Dodd-Frank "reforms" and replace it with state anti-gambling and anti-bucket shop laws.
The squealing of the stuck pigs would be music to ones ears....
We'll come back to this later this month. In the meantime here's Reuters:

Closing Wall Street’s casino
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.

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.....MORE
HT: Economists View, Links for 2011-11-20

Back in April 2010 Economics of Contempt argued against the use of state anti-gambling laws to regulate securities firms:
Preemption of State Anti-Gambling Laws

I believe his argument is a straw man but even if you stipulate that it is pertinent there are still the anti-bucketshop laws which made "side-bets" illegal.

Here's the U.S, Senate testimony of Eric Dinallo, then-Superintendent of the New York State Insurance Department on October 14, 2008 (8 page PDF).

...I have argued that these naked credit default swaps should not be called swaps because
there is no transfer or swap of risk. Instead, risk is created by the transaction. Indeed, you
have no risk on the outcome of the day’s third race at Belmont until you place a bet on
horse number five to win....

...“Bucket shops” arose in the late nineteenth century. Customers “bought” securities or
commodities on these unauthorized exchanges, but in reality the bucket shop was simply
booking the customer’s order without executing on an exchange. In fact, they were
simply throwing the trade ticket in the bucket, which is where the name comes from, and
tearing it up when an opposite trade came in. The bucket shop would agree to take the
other side of the customer’s “bet” on the performance of the security or commodity.
Bucket shops sometimes survived for a time by balancing their books, but were wiped
out by extreme bull or bear markets. When their books failed, the bucketeers simply
closed up shop and left town, leaving the “investors” holding worthless tickets.

The Bank Panic of 1907 is famous for J.P Morgan, the leading banker of the time, calling
all the other bankers to a meeting and keeping them there until they agreed to form a
consortium of bankers to create an emergency backstop for the banking system. At the
time there was no Federal Reserve. But a more lasting result was passage of New York’s
anti-bucket shop law in 1909. The law, General Business Law Section 351, made it a
felony to operate or be connected with a bucket shop or “fake exchange.” Because of the
specificity and severity of the much-anticipated legislation virtually all bucket shops shut
down before the law came into effect, and little enforcement was necessary. Other states
passed similar gaming or bucket shop laws. Interestingly, to this day, companies wishing
to use the world “exchange” must receive permission from New York State.

Thus, the various bucket shop laws essentially prohibit the making or offering of a
purchase or sale of security, commodity, debt, property, options, bonds, etc., upon credit
or margin, without intending a bona fide purchase or sale of the security, commodity,
debt, property, options, bonds, etc. If you think that sounds exactly like a naked credit
default swap, you are right....
More to come