Lynn A. Stout is the Paul Hastings professor of corporate and securities law at UCLA's School of Law. This op-ed appeared originally Oct. 7 at the New York Times DealBook blog.
What caused the 2008 credit crisis? Loose monetary policy surely played a part. So did compensation plans that encouraged executives to take huge risks in the quest for short-term profits. But one fundamental cause of the credit collapse remains largely unrecognized and largely unaddressed: Congress’s decision in 2000 to legalize over-the-counter derivatives trading.
O.T.C. trading in credit default swap derivatives, or C.D.S.’s, brought our banking system to its knees.
The crisis began when the insurance giant American International Group disclosed that it had suffered huge losses trading C.D.S.’s, derivative bets that companies or municipalities would default on their bond obligations. Because A.I.G. was part of an enormous and poorly understood web of derivative bets and counterbets among the world’s largest banks and investment funds, many of these institutions feared that if A.I.G. went bankrupt, they would too. Only a $180 billion government bailout kept the system from imploding.
We could have avoided this if we had stuck with traditional derivatives regulation.
Wait a minute, some might say. “Traditional” derivatives regulation? Aren’t derivatives new, innovative financial products that have never been traded before?
No. Derivatives have been around for millennia. (The Babylonians used derivatives to bet on trading caravans). Although Wall Street traders and finance professors like to surround derivatives with confusing jargon and mathematical equations, behind the smoke lurks a simple reality: a “derivative” is only an agreement to pay or receive an amount of money determined by future changes in some interest rate, asset price, currency exchange rate or credit rating.
In other words, derivatives are bets — nothing more. Just as you can gamble on which horse will win a race and call your betting ticket your “derivative contract,” you can gamble on whether interest rates will rise by entering an interest rate swap contract, or bet on whether a bond issuer will repay its bonds by entering a credit default swap contract.
Bets can be used to hedge risks. A homeowner, for example, hedges by purchasing fire insurance, essentially betting the insurance company the house will burn down. If the house burns, the homeowner “wins” the bet, offsetting the loss of the house. (Wall Street traders might call homeowner’s insurance “housing value swaps.”) Similarly, an investor who owns a bond and is worried the issuer might default can buy a C.D.S. and bet against the issuer’s creditworthiness. If the bond decreases in value, the C.D.S. increases.
But bets can also be used to speculate, and speculation creates risks where there were none before. This is especially true when speculators who make different predictions trade with each other. (One thinks interest rates are going up; the other thinks they’re going down.) When a speculator trades with another speculator, both take on new risks they weren’t exposed to before, just as gamblers take on new risks when they go to casinos.
This is why healthy economies generally regulate gambling, especially large-scale derivatives gambling. For at least the last two centuries, the United States regulated derivatives using a two-prong approach. Speculative trading was allowed on organized exchanges like the Chicago Mercantile Exchange and the New York Stock Exchange, where trading could be overseen first by private governing bodies and later by the Commodity Futures Trading Commission and the Securities and Exchange Commission. Outside the exchanges, O.T.C. derivatives speculation was discouraged by a common law rule called the “rule against difference contracts.” (“Difference contract” is the 19th century term for derivative.)
The rule against difference contracts, along with a sister doctrine in insurance law called the “insurable interest” requirement, treated O.T.C. derivative contracts as enforceable only if one party was using the contract to hedge a real, pre-existing risk. For example, you couldn’t collect insurance on a house you didn’t own or hold a mortgage on. Similarly, you couldn’t enforce a C.D.S. contract unless one of the parties to the contract owned or had a direct economic interest in the underlying bond on which the C.D.S. was written. “Naked” C.D.S.’s of the type that brought down A.I.G. were unenforceable.
The result was to keep derivatives speculation in check and largely confined to organized exchanges. At least, speculation was kept in check until the rules were dismantled. The dismantling began in 1986, when Britain “modernized” its laws by making all financial derivatives, whether used for hedging or pure speculation, legally enforceable. American regulators followed suit in the 1990s by legalizing O.T.C. trading for particular types of financial derivatives, especially interest rate swaps. This promptly led to the swaps-fueled bankruptcies of Orange County, Calif. (1994), Barings Bank (1995), and the Long-Term Capital Management hedge fund (1999). Despite these object lessons, Congress embraced wholesale legalization of O.T.C. derivatives in 2000 with the Commodities Futures Modernization Act.
That act declared O.T.C. derivatives exempt from C.F.T.C. or S.E.C. oversight. But it also declared even purely speculative O.T.C. derivatives contracts legally enforceable. The Commodities Futures Modernization Act thus eliminated, in one move, legal hurdles to derivatives speculation that dated back, not just decades, but centuries. It was this change in the law — not some flash of genius on Wall Street — that created today’s huge derivatives market. According to the Bank for International Settlements, by 2008 the notional value of the derivatives market had climbed to $600 trillion, amounting to nearly $100,000 in derivative bets for every man, woman and child on the planet.
This “modernization” has added enormous risk to our economy, making it possible for institutions like A.I.G., Orange County, Barings and Long-Term Capital Management (not to mention Enron, Bear Stearns and Lehman Brothers) to lose very large amounts of money very unexpectedly.
Of course, derivatives speculation in theory may provide social benefits that offset the social costs of systemic risk. Economists, for example, often claim speculators add liquidity to markets, and improve the accuracy of market prices. Yet there is virtually no evidence that legalizing speculative O.T.C. derivatives trading has provided significant benefits to the overall economy (although it clearly has provided benefits to Goldman Sachs and other winning derivatives traders). Meanwhile, taxpayers have spent nearly $180 billion on the A.I.G. bailout alone.
What to do? One possibility is to simply go back to what worked before. Lawmakers have started to move in this direction. The Treasury, for example, has proposed requiring “standardized” derivatives be traded on regulated exchanges, allowing only “customized” derivatives to be traded on the O.T.C. market. Unfortunately, the “customized” loophole is large enough for Wall Street to drive not just one, but several, trucks through.
An alternative might be to learn from history and the common law. By refusing to enforce off-exchange derivatives that didn’t serve a true hedging purpose, the old rule against difference contracts preserved the economic benefits of hedging transactions while discouraging the sort of large-scale, unrestrained derivatives speculation we have now learned, the hard way, can add intolerable risk to the financial system. And it did this without spending taxpayer money. During the 1990s boom, when O.T.C. derivatives were widely applauded as new financial “products” and “innovations,” this traditional approach had little appeal. It might have more now.