David Cay Johnston 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.

Unenforcable 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.

—David Cay Johnston

This entry was posted on Friday, November 18th, 2011 at 12:17 pm and is filed under Evil Speculators, General. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.