Sunday, Oct. 19, 2008 | 2 a.m.
If you want a single fact to help you understand the nation’s financial mess, consider this:
The credit default swaps behind so much of the meltdown were so risky that federal authorities feared that state governments might try to ban them as illegal gambling.
Then consider this:
Not only did Washington purposefully let these instruments flourish in the market without traditional federal oversight, but Congress passed legislation banning any state from stepping in to regulate this kind of gambling.
Call it the Vegas loophole. It shows as plainly as any single fact that Washington, or at least some of those involved, knew the risks being ignored.
“They were gambling,” said University of Maryland law professor Michael Greenberger, a former federal regulator who pushed unsuccessfully for oversight a decade ago. “You would have been better off gambling in Las Vegas than taking these investments, because at least the casinos in Vegas are regulated.”
Without securities laws on one side or state gaming laws on the other, these newly popular credit default swaps were let loose to grow into the $60 trillion unregulated industry it is today.
That’s trillion with a T — greater than all the world’s economies combined.
Now as the credit markets implode in their biggest crisis since the Great Depression, it’s known that credit default swaps played a central role. Many of them insured securities backed by bad mortgages.
Swaps led to the federal government’s shocking takeover last month of insurance industry giant AIG, and they now permeate — some say infect — the global credit markets in ways experts cannot completely understand or quantify.
So troubling is this vast shadow market that Christopher Cox, President Bush’s chairman of the Securities and Exchange Commission, calls it a “regulatory black hole” that Congress must address immediately.
Wall Street is always a gamble, as investors are coming to realize as they open 401(k) statements this month.
We buy stock in a company because we think the value will rise. Maybe it does, maybe not.
Credit default swaps are not too far afield from other financial instruments used to hedge risk, which is a vital part of business. Swaps are a form of insurance that investors buy in case their trades go south. You and I don’t use them, but big investors do.
In many ways, swaps are no different from the futures contracts farmers buy to hedge the price of wheat or the insurance banks take out to protect against interest rates going up or down. Even ski slope operators can bet that the sun will shine in February — if it does, and they have no snow, they’re covered.
But other markets have built-in oversight through regulatory agencies. Companies must disclose certain information if they want their names listed on the exchanges. Regulators at the Securities and Exchange Commission or the Commodity Futures Trade Commission are paid to keep watch.
Swaps are traded over a computer, over the counter as it’s called, and as the industry grew without oversight, there was no cop on the beat to keep track.
Experts now say there is no real understanding of how vast swaps trading is today. There’s no way of knowing how many swaps have been bought and sold, or if the companies backing them have the ability to pay the claims.
Even more, the vast majority of swaps trading, perhaps 90 percent, is being done by speculators rather than hedgers — those with no underlying asset to protect who are simply betting on which way the market will go.
In many cases, they bet that subprime borrowers would default on their mortgages. (“They won,” notes Greenberger, the former federal regulator.)
As stocks went south and insurers couldn’t pay up, it unleashed a domino effect now threatening the entire system.
“The regulatory black hole for credit default swaps is one of the most significant issues we are confronting in the current credit crisis,” SEC Chairman Cox said in a speech this month. “It requires immediate legislative action.”
Billionaire Warren Buffett calls such derivatives “financial weapons of mass destruction” if used improperly.
As the popularity of swaps grew in the 1990s, federal regulators at the Commodity Futures Exchange Commission wanted more oversight, but were shot down at the highest levels of government.
Washington wanted this new market to remain unfettered because insurance allowed companies to leverage their credit, much the way mortgage insurance allows a homeowner without a down payment to buy a bigger house. They worried that even talking about regulating the swaps would seize up the credit market.
To prevent regulators from getting the upper hand, the Republican-led Congress passed the Commodity Futures Modernization Act of 2000. President Clinton signed it into law.
Washington’s mind was elsewhere that winter as the U.S. Supreme Court was deciding the fate of the disputed 2000 presidential election. Then-Sen. Phil Gramm of Texas, who until recently was an adviser to Republican presidential candidate John McCain, engineered the bill’s passage on the final day of Congress.
The legislation established swaps as agreements between willing parties out of reach of federal regulators.
Lawmakers, knowing they had a potential problem with the states, had the foresight to insert the little-noticed preemption of state gaming laws.
Eric Dinallo, the New York insurance commissioner who recently spent a long weekend helping to engineer the federal bailout of AIG, described the action succinctly this month. “In one fell swoop,” the new law established that swaps “are not a security, and they’re also not subject to the gaming laws of the land.”
“And now we’re $63 trillion to the worse,” Dinallo told a House committee.
Lawmakers have not been pleased to learn that Vegas-style odds are the center of nation’s financial crisis.
“So are those products just gambling?” an incredulous Rep. Carolyn Maloney, Democrat of New York, asked at a hearing. “We banned it in New York state. And then the commodities law usurped our position.”
Committee chairmen in the House and Senate say they will lead the charge to change the law.
“By God, we’re going to know what’s going on with this stuff out in the open,” said Rep. Collin Peterson of Minnesota, at the close of a hearing before his House Agriculture Committee, which has jurisdiction over swaps as it does farm futures. “Folks are going to have to get real.”
Industry advocates say swaps have been maligned by those who don’t understand their importance to the financial system, and warn that over-regulation will simply put trading offshore out of regulators’ reach.
Richard Lindsey, former president of Bear Stearns’ brokerage division, decried in Senate testimony last week the “frequent and shrilly” insistence that swaps are bets. Swaps are no different from exchanges happening in the futures markets, he testified.
Lindsey explained later that exempting financial instruments from gaming law is “standard procedure” so traders are not met with a patchwork of state regulations.
“You could have essentially any state prosecutor coming after those,” said Lindsey, also a former Yale finance professor and Securities and Exchange Commission regulator. Saying swaps are unregulated is an overstatement, he says.
“In a modern financial world you need these instruments,” he said, and the financial markets would shut down without them.
But William Black, a professor of law and economics at the University of Missouri at Kansas City, who also testified before the Senate panel, said taking away states’ regulatory authority without the backup of a federal law is “absolutely indefensible.”
“It was a colossal mistake,” Black said. “I would add: A colossal bipartisan mistake.”
In New York, Gov. David A. Paterson has announced that his state on Jan. 1 will begin regulating the small portion of swaps market that actually covers assets as if they were insurance policies, with mandated capital requirements.
But without a change in the federal law, states cannot go after the vast majority of trades being done by speculators. The Nevada Gaming Commission, which oversees the nation’s most sophisticated gaming regulatory apparatus, has no authority to step in.
Imagine, if casinos wanted to get in the swaps action. Or to stop it.
Greenberger said the notion of crafting a federal law that insisted on pre-empting gaming laws is “sort of embarrassing ... What kind of federal law are you proposing?”
But without it, “they would not have been able to achieve what they were trying to achieve, which was complete deregulation,” he said.
“They wanted everything.”